Having been involved in several conversations about the calculation of net worth recently, I’ve come to the conclusion that net worth isn’t that important to know. The reason? Net worth is a very difficult number to analyze, and the difficulty in analyzing it makes it a somewhat worthless tool for measuring progress in your financial life.
1. You don’t know how it’s calculated. A lot of people include home equity in that calculation (value of the home less mortgages/loans against it). I don’t include it, because I believe that it’s not a value you can “cash in.” If you cash it in, you still have to buy a new place to live. The only way to “cash it out” is to sell and then move into a rental or downsize, which is not a typical move most people make these days. The counterpoint is that it is an asset that you can borrow against; a bank will give you a loan against that value. Regardless, you just can’t know if people include it or not.
2. A net worth of $200,000 means different things in a small town in Texas and in La Jolla, California. In one place it’s a substantial amount that could generate a sustainable income. In the other place it’s lunch and a tip. Many of us may know that we’re staying put our whole lives, but many of us might be living practically anywhere in 20 years. Knowing whether you’ll be living in Smallville or Gotham would make a big difference.
3. Net worth doesn’t accurately measure cash flow generation. If you have an asset (a rental property, etc.) that generates cash flow, is that worth the same as one that doesn’t (like bricks of gold or a non-dividend paying stock)? In the long run, of course, that cash flow adds to net worth, but the potential future accumulation of cash isn’t really represented in a snapshot view of net worth. That’s not the purpose of a net worth calculation, but it is a problem with analyzing it.
4. Net worth also doesn’t show risk. If I have $500,000 invested in equities, is that the same as $500,000 invested in a money market? Again, for a snapshot in time, yes, but one of them is substantially riskier than the other. If you could apply some sort of risk calculation to your holdings it might make a difference in how you look at the overall picture, as well.
I don’t think it’s all that important to know your net worth. If you use it for motivation or simply feel better knowing what it is, by all means do so. But just like knowing that Harold weighs 200 pounds isn’t that helpful in getting a picture of him unless you also know whether he’s 5 foot 3 inches or 6 foot 8 inches, or whether he’s solid muscle or flabby, knowing your net worth doesn’t tell you everything you need to know about your financial position. It’s part of the picture, but definitely a small part.
This post was inspired by Moolanomy’s net worth writing project. Here’s what other people who participated are saying about net worth:
- December Net Worth Review @ Single Guy Money
- Net worth 2008? @ Plonkee Money
- Net Worth: 43% Growth in 2007 and Goals for 2008 @ Cash Money Life
- How we increased our net worth by more than 170% in less than a year @ Gather Little By Little
- I’m in the black @ Being Frugal
- @ I’ve Paid For This Twice Already
- The M-Network Shares Their Net Worth – You Know You Want To Peek! @ My Two Dollars
- December 2007 Site and Net Worth Review (+0.72%) @ Moolanomy
- @ DebtFREE-Revolution
- New years net worth – paid down debt in 20087 and bolstered savings @ Mrs. Micah
- 2007 Net Worth Update: +19.7% @ My Dollar Plan
- Net worth for the new year @ Rocket Finance
- @ Credit Withdrawal
Note: Just because of the busy holiday weekend, guests, etc. I fell behind on my blog reading so I didn’t have many starred for a link roundup. I participated in two carnivals this week, and hopefully I’ll get through those and have a few links from the carnivals and my general reading by Saturday. Also, Emily was the winner of the “mystery CD” and I’ll leave it up to her to disclose what it was when she gets it.