net worth or net worthless?

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:

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.

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  • http://freefrombroke.com/ Free From Broke

    I agree that it’s all relative. It really shouldn’t be a bragging point for sure. But it makes for a great motivator when you are overall in the red! Crossing the threshold into black is like a monkey off of your back. It’s a great point though that any number for your net worth needs to be seen in a bigger picture of things.

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  • http://hunternuttall.com/ Hunter Nuttall

    Steve, I definitely agree that not knowing how it’s calculated is a big issue. I count home equity in my net worth, because to me the ability to cash in is not a consideration of net worth. (I have many investments that I know I will never sell, but I count those as well.) If you want to buy a franchise, your home equity may very well not count towards the minimum net worth requirements, specifically because you can’t cash it in.

    On the other hand, I don’t count “stuff” in my net worth. When I paid cash for my car, my net worth took an instant $14,000 hit. But some people would include cars, furniture, TVs, etc., making for very inconsistent comparisons.

    Maybe I think net worth is a bigger part of the picture than you do, but I agree that it’s just part of it.

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  • http://www.rocketfinance.net rocketc

    Networth might be more valuable for those of us who have high levels of debt. It gives a more positive picture of our financial situation than just looking at the pile of cash that we owe – possibly false picture – but motivating never the less.

  • http://www.moneysmartsblog.com/ FourPillars

    Great post. Very similar to the one I was thinking of writing :)

    When I first became “financially aware”, I kept track of net worth because it was a great motivator for me. However at that time my net worth was basically made up of my debts so my “net worth” was really a proxy for my debt. Later on I stopped calculating the net worth because the changes in net worth didn’t track my actions ie house value/markets might go up or down which had nothing to do with my contributions or debt payments.

    As you also mentioned, a more relevant calculation is to look at the income you can derive from your investments and compare that to the income you need to live on.

    Mike

  • http://cashmoneylife.com Patrick

    Steve, I think this is a great article, and very much in line with my views (although I did use of house in the calculation). I don’t often write about net worth, especially my own, because as you mentioned, it is arbitrary. However, I think knowing certain things such as the total value of your retirement holdings, cash flow producing assets, and other sources of money or equities is very important, especially when preparing for retirement. One of the things most people do not include in their net worth is their income from their job or other sources, which is not technically part of your net worth, but is most often the most valuable asset you have.

  • http://www.guinness416.com guinness416

    As long as you know how your own net worth is calculated, that’s all you need for comparison quarter to quarter, no? I do keep track of it, though somewhat haphazardly, as both a motivator and an occasion to sit down and check all my accounts (I have accounts of one sort or another in four different countries…) to make sure nothing’s going wrong in any of them. If I graphed it, it would look insane I’m sure, in the last few years I’ve sold an aprtment in one city, bought a house in another, done some renovations, imported a car, gone from one to two to one households, and on and on. But I stop short of tracking market price for my house because that does seem a pointless exercise to me, and frankly I just couldn’t be bothered. And like Hunter, while I have a relatively detailed home inventory for insurance I don’t calculate any personal belongings … which is always the most curious line item for me in any of the published net worth calculations, some people including $50,000 and some $5,000.

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  • http://www.moneysmartsblog.com/ FourPillars

    One of the things most people do not include in their net worth is their income from their job or other sources, which is not technically part of your net worth, but is most often the most valuable asset you have.

    Patrick – interesting statement.

    A few years ago I almost got laid off from my job and I went through a quick exercise where I looked at my assets (that I could earn income from), debts, costs etc and realized very quickly that my income is indeed my biggest asset.

    This might not be true for someone who is getting close to retirement.

    Mike

  • http://cashmoneylife.com Patrick

    Stay tuned, Mike. I plan on writing about that for tomorrow’s article. ;)

  • http://www.homelist.org/ The Investor’s Journal

    I think we all know net worth is just a bragging right. It means little in terms of knowledge of money, means to grow and protect your money, etc.

  • http://minussign.blogspot.com/ ed

    Certainly a very interesting and informative post in the least. As I read it I find myself thinking back to one of my fiance’s former bosses.

    He essentially generated all of his income with his existing bank account. He bought and ran franchises, more or less. He was the kind of guy really concerned about his net worth and how it reflected onto him as a person.

    He even went so far as living in a ritzy area, Bedford, NH. But his home paled in comparison to all those around him (200k range, when everone else has 800k+)

    In the end of things, no matter how much he was actually worth he couldn’t come up with the liquid assets to open up any of the big cash cow franchises, like McDonalds, Dunkin’ Donuts, et cetera. Every cent he had was tied and hard to cash out.

    So you certainly make a point, and it’s a breath of fresh air to hear someone blogging about net worth like a tool, versus a score in Pacman.

  • http://earlyretirementextreme.com/ Early Retirement Extreme

    I think net worth is about as useful as equity in evaluating a company. I have had some fun lately in evaluation my finances as if I was a company e.g. making an equivalent balance sheet, income statement and cash flow statement. Rather than net worth (which I also hate, when it is used as a bragging point) I think the pertinent numbers are profit margin (which is the equivalent of savings rate), and free cash flow. For home owners, debt to equity is also important. Overall, I think it comes down to what kind of financial lifestyle one leads. For instance, if I had millions, I wouldn’t care about income since I could never spend that amount of money anyway, whereas for early retirement purposes, the profit margin is an important measure of financial independence and the free cash flow says something about post retirement capabilities.

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  • moneymonk

    Net worth is never perfect, we can only guessimate

  • http://remodelingthislife.wordpress.com Emily

    This sounds like the conversation hubby and i had about net worth last week. I think it can be motivating on an individual personal level to increase your net worth but when comparisons start flying, it’s just not a very useful tool.

    Great post!

  • SavingDiva

    I LOVE to calculate my networth. I wouldn’t say that it’s a valuable tool. However, calculating my net worth at the end of every month makes me re-evaluate my investment decisions (currently only my retirement accounts and mutual fund).

    I agree that net worth isn’t a great comparison tool (plus, I’d sounds like a total tool if I said that I was worth $20k at dinner) with others. However, I think it’s a great tool at comparing your current situation to your past situation.

  • http://www.rocketfinance.net rocketc

    Too bad “tool” isn’t a good google key word . . . :)

    I am going to announce my networth at dinner tonight. I wonder what my 3 year old will think?

  • Dasha

    I just think of all the Jane Austen novels when I think of net worth.

    Net worth = value on marriage market

    :)

  • http://www.bripblap.com Steve

    Great comments! I should point out that I don’t dismiss net worth’s value as a motivational tool. Weight loss is again a good comparison. If I tell you I lost 50 pounds, it makes a big difference if I weighed 250 pounds or 600 pounds as to whether it’s an impressive loss.

    I do think net worth is helpful as a motivational tool. I just think that it’s overused as a personal finance tool. If you work in finance, you realize that equity is only one measure of a company’s health. A million other things indicate growth or stagnation or decline: cash flow, return on equity, profit and loss, earnings before taxes, etc. I personally have tried to shift my thinking to “earning power” – what could I generate in cold hard cash from my assets? That’s the true measure of financial freedom.

  • http://fathersez.wordpress.com/ fathersez

    I also lived in a false world for a while basking on my net worth. (with house included).

    I agree that cash flow generation should be a better metric to focus on.

    This is what we should keep making better.

    Now I just have to figure out how.

  • http://paradigmshifted.org/ deepali

    I don’t calculate networth per se, but I do keep separate running tabs of my debt, my retirement, and my savings accounts. These will give me a good snapshot. Of course, it depends on which day that snapshot is taken!

    Having studied statistics, I find a moving average to be more useful (also a useful tool for weight loss, and google will do that one for you). It gives me the “true value” amongst all the noise. It has its limits, though, because it would depend on which statistical model would be used (I like a simple regression). It also doesn’t answer the question of whether to include the house, though it does address the income question.

  • http://www.thefinancialblogger.com The Financial Blogger

    It is true that you can argue forever about what should be included in your net worth or not. However, if you stick to the same calculation years after years, it could be a great help in order to design a financial plan.

    Your net worth progress is an indicator (not the only one) of your financial health. If it’s stable or decreasing, then you should take a closer look at your investment portfolio or your budget.

    You also have to determine why your net worth is increasing. if the house pricing is going up in your area or if you made a major capital gain for one year, you might not be doing so well in reality.

    Here are more thoughts about including your property or not in your net worth : link.

    (Note from Brip Blap: the URL was too long for the comment format, so I HTMLed it. Still directs to same post).

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  • http://themoneygardener.com/ moneygardener

    Great post…. but I disagree with almost every argument you’ve made.

    I will endeavour to post about this on my blog in the next week or so..

  • hank

    I like it – and agree to a point; but at the same time it has made me very aware of what and where my money is going. I think it can take a huge tangent when you start to say WHAT is defined in it. If you keep it simple, I think Flexo might have mentioned it months ago in a post I read, net worth is what you’re worth if you had to sell everything you own right this minute. If you did, how much money would you have?

    For me it is more of a bookmark on my financial “novel”…

  • http://themoneygardener.com/ moneygardener

    Here is my rebuttal

    (Note from Brip Blap: the URL was too long for the comment format, so I HTMLed it. Still directs to same post).

  • http://aprivateportfolio.blogspot.com/ traineeinvestor

    As interesting as the post is , I’m with moneygardener in respectfully disagreeing with just about everything in the post.

    The fact that “net worth”may be measured differently by different people and different amounts may have different relative meanings to different individuals does in no way detract from its usefulness as a personal finance tool. For me, net worth calculation is the primary measure of progress towards my retirement goal (although other measures are also relevant).

  • http://www.bripblap.com Steve

    I’m perfectly OK with disagreements with my conclusion. I think my point was more that it doesn’t serve much purpose as a comparative tool, and it depends heavily on factors that aren’t included in the calculation as to whether your net worth is “good” or “bad.”

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  • JimB

    This is a really great post. Too many people use “net worth” to keep score in life and many investment firms use it as a marketing tool. It clearly changes over time depending on which asset classes you are invested in.

  • http://www.bripblap.com Steve

    Thanks, JimB. That’s another avenue I didn’t really even get into – that the term “net worth” is being used as a marketing tool to make us feel inadequate. My net worth isn’t as high as Fred’s!! Let’s invest in pork belly futures!

    Good point!

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  • http://www.lazymanandmoney.com Lazy Man and Money

    I think it has value to the individual which you touched on at the end of the article. It is difficult to understand what it means to other people unless they know the other details that you mentioned.

    In my case, I’m pretty open with most of the extra information. People know what I’m invested in (to some degree), how it’s calculated, and where I live.

  • http://7million7years.com/ 7million7years

    Halleluja Brother! Net Worth don’t mean no hill o’beans because you have to guess at the valuations of all of them little ol’ businesses and investment real-estate that produce all of that sweet cash.

    Mah own little ol’ net worth just kept climbin’ and climbin’ as I sold off those little ol’ income-producing assets and businesses to big, fat corporations with deep pockets … suggest y’all do the same using some of the same tricks o’the trade that ah did … c’mon over, pull up a chair, and sit by the fire and ah’ll tell y’all about ‘em …

  • http://fwdservice.com/?dmn=knowtheledge.org&folio=212511050 Know The Ledge

    I’ve always struggled with the importance of the net worth number and it’s relevance. It’s definitely all relative, and think that a different calculation based on your level of financial freedom might be more prudent. That could take into account your regional differences as well as give you some practical information to use.

    It would be less a figure to compare between you and others, and more a figure to compare between you and yourself, which makes it ultimately more valuable to your financial progress.

  • http://firstgenerationwhitecollar.com/blog/ Moneymonk

    I wrote a post close to this a while back.

    I just think cash flow is always better than net worth. It is cash flow that will keep you going.

    http://www.moneymonk.net/2008/03/net-worth-is-j

  • ldk

    net worth is relevant as a continuing benchmark for your own purposes…say every 6 months to a year….though using it to compare yourself to others is rarely useful. Risk and the extent of your diversification would eventually reveal themselves though either rapidly growing or shrinking net worth as people who were largely or solely invested in their primary residences have found out. Also, one would assume that assets with positive cash flow would also reveal themselves as that cash flow is used to save, invest or buy other assets…if it is spent on crap then it is irrelevant anyway!

  • ldk

    net worth is relevant as a continuing benchmark for your own purposes…say every 6 months to a year….though using it to compare yourself to others is rarely useful. Risk and the extent of your diversification would eventually reveal themselves though either rapidly growing or shrinking net worth as people who were largely or solely invested in their primary residences have found out. Also, one would assume that assets with positive cash flow would also reveal themselves as that cash flow is used to save, invest or buy other assets…if it is spent on crap then it is irrelevant anyway!