the worthlessness of net worth

Having been involved in several conversations about the calculation of net worth, 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.  And if you’re honest, none of us know – for sure. 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.

  • http://www.moneybeagle.com Money Beagle

    I don’t think it’s worthless but I don’t think it should be the only number you track, either. It should be one of several pieces of information that you use, over time, to track how you are doing financially. I’ve had my net worth calculated for almost ten years now and it’s painted a good picture of what has happened financially over those years.

  • Big-D

    Steve, while I value your opinion, I think you are dead wrong. I think net worth can be a valuable tool to one’s self to see a snapshot of their own value. Do you think a balance sheet is worthless to a company or investor. Yes they don’t really break everything down, and show the nitty gritty details that you are looking for, but that is what an researcher does (S&P, Moody’s, etc.) As for the same thing for your personal life, there are people that do this, and they are called financial advisors. You pay them money and they tell you your financial position in the nitty gritty detail you are talking about. I will break down each of these 4 and give you an alternate opinion.

    #1 The only way calculating it differently is of relevance is if you are comparing it to another person. If you calculate it the same way, every time, just like accounting, it becomes significant in showing differences over time. So if Benny and June calculate it differently, you cannot compare their net worths. However if you calculate yours the same way over a period of 5 years, then you can get a good perspective of your calculation of this value, however your did it.

    #2 Let us assume you have overcome hurdle #1 and both are doing calculations identically. Great. Now you live indifferent zip codes and 90210 is not the same as 46260. So what? Unless you are trying to show off your net worth like the latest bling to a rapper, who cares? Net worth is more of a personal benchmark and not really a number that has to be compared to others. And most who compare those numbers are in the same zip code anyways, keeping up with the jones’s.

    #3 So what if you don’t know cashflow from net worth? That is like asking to find out how many home runs a slugger hit from just looking at their batting average. They calculate two different things. That is the nature of formulas and calculations.

    #4 See #3. Again – there are measures of this, and you can use a financial advisor to determine the risk of your investments/portfolio.

    What I am seeing as the crux of your argument is that net worth does not give you the whole picture of your financial health. However going as far as saying it is worthless I think is a bit over dramatic. You might not care about it because you are focused on other things. Back to baseball. What you are saying is that you have a baseball hitter, who is batting .333. Batting average is just like net worth, it is an average of your overall batting. What you are saying is something like “I could care less how well he hits in general, I only care about how well he hits with runners in scoring position.” Now they have a measurement for that, called RISP .. however you are going so far as to call batting average worthless. I think that is a bit melodramatic.

    In the end, I think you could say something along the lines that net worth can be a snapshot but should not be the only thing you look at for determining financial security.

    • http://www.bripblap.com Steve

      All of those are very valid points. I’ll admit, as I often do, to a bit of ‘hucksterism’ or whatever you want to call it in my titles. I tend to blow things out of proportion to get people to read it… ‘spend less than you earn is the wrong way to think’ etc. And yes, of course, if you use net worth as a tool for your own progress it’s fine. I first came up with this idea when I saw a blog – can’t remember which – that listed something like ‘top 10 bloggers by net worth’ or something like that. Your point #1 is really the heart of my argument. But a great response, Big D: your comment is a blog post in and of itself!

  • Kelly

    I agree with some of your points, however, I don’t feel it is worthless at all. I was going to say similar points as Big-D but he said it much better so I’ll leave it at that :)

    I personally use net worth as my own score. I don’t compare it against anybody else and it is calculated the same every month. This way I know I’m on the right track when it consistently climbs. If there is a big drop or gain it prompts me to look deeper for the cause and hopefully fix a problem (if it is something I had control over) or make changes to repeat what caused the gain.

  • Pam McCormick

    I really appreciated reading the “other side of the coin” so to speak.I have always worried about my net worth especially when you see lots of people shouting figures at you like”you need 1 million to retire” etc.So finally I read somewhere kind of a common sense approach.Then I applied to my personal numbers.I took what I need every month to run the house and multiplied by 4% for inflation.I wrote down 3 budgets,1-only basics like food/water etc no house payments or car payments or cable(laughing here its a joke) 2 budget with luxuries like cell and cable,3rd budget with travel dollars say 10K per year so if we should be so lucky.THEN I calculated what we can count on coming in like pensions-401K/403b-income if any and savings.Suddenly my family seems in ok shape and on our way towards 1 million IF necessary.We live very simply and don’t need a whole lot to cover our basics even with keeping cable(sorry-I’m just sayin)

  • http://earlyretirementextreme.com Early Retirement Extreme

    Net worth is essentially what book value is for a company. It’s a useful number, but it’s not the only one needed to judge the quality of the situation.

  • Janette

    I track net worth without the house—Never could figure out how much that is worth anyway!
    The tracking keeps me up on which investments are working, and which do not. It helps me feel secure in what we have done so far.
    Now if I could only teach my husband that when you sell stock for a huge profit- you only reinvest the base and not the profit…

  • Cathy Moran

    Better focus on net worth than on credit score, which is what lots of my bankruptcy clients think is the meaningful number. Whatever the methodology or the assumptions, calculating net worth is a healthy exercise.

  • threadbndr

    I actually run my numbers with and without the house/tax escrow accounts. Like @Kelly, I run my numbers in order to track trends.

    What I find most useful, though, is tracking spending and ‘non-salary’ income. Forcing the first down and the second up is a monthly game that I play with myself to keep focused on my goals.

  • http://www.personalfinancemastery.com Darla Serrano

    I have to disagree with you, Steve. While you list some compeling reasons why net worth isn’t important to know, you’re missing one very important point: Insurance Coverage. How do you determine how much personal insurance protection to buy for your home, auto, life, and umbrella policies if you don’t know your net worth? Insurance is used as a risk management tool. If you don’t know your net worth, you can’t calculate exactly how much insurance you really need to cover your assets. One of two things will happen; either you are over-insured and overpaying for insurance premiums, or you are under-insured and run the risk of losing everything.

  • Eli

    While not worthless, it definitely doesn’t tell the whole picture. One way to normalize would be to divide by annual living expenses (not income). This would be similar to calculating months of an emergency fund, but would be more relevant to judge retirement readiness. It would also change significantly as soon as the house is paid off, so it would incorporate housing “equity” in that sense. You could also forecast net worth divided by annual expenses several years into the future to account for paying off a home, etc.

  • Erickson

    The worth (or worthlessness) of net worth depends upon two things. How you define self worth. And your future financial plans. If you judge your self worth in financial terms, net worth matters. Or if you plan on leaving assets to heirs or charity, net worth matters.

    Otherwise, net worth does not matter. Only cash flow, and the sustainability of that cash flow, matters.