what’s the point of net worth?

Having been involved in several conversations about the calculation of net worth over the years, I’ve come to the conclusion that net worth isn’t that important. The reason? Net worth is a difficult number to analyze, and the difficulty in analyzing it makes it a 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, for example (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.  Since I moved from New York City to a small town in Florida I’ve understood this statistic better than ever.

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.

11 comments

  • Net worth updates are definitely fun to read and check on with bloggers, but you don't see the whole picture. I have net worth updates as a way to keep myself on focused. Its nice to set aside a day and just review our budget and our accounts with each other.

  • I read these arguments often and they are universally unpersuasive. There is nothing difficult about calculating your net worth, unless you arbitrarily decide to exclude certain assets or liabilities (e.g, your home equity or lack of same) for irrelevant reasons. For example, ask the people who are underwater and broke if they should have monitored their net worth before and after they bought their home. Tell me a metric that is more indicative of your personal financial progress? Credit score? Please. Whenever our small business wants to renew its line of credit, the lender asks for personal financial statements (including net worth calculation) from the owners. Why do you think that is? Because credit scores don't guarantee repayment when tthe cash stops flowing. Net worth does.

    • @MrToughMoneyLove: I wouldn't make the argument that credit score is a better measure at all. As I said, if you feel that the calculation is beneficial, by all means do it. I never monitored my net worth (and truth be told, still don't) because I feel that my attention is better spent on core principles that increase net worth: frugality, increasing my income, and never ever incurring non-mortgage debt. I never needed to know my net worth – and still don't – as long as I've practiced these things.

  • Hey Steve,

    This is an interesting take. I agree with much of what you've said about the networth being more of a snapshot versus a true, complete analysis of one's financial position.

    I've worked with people who have multi-million dollar net worths (largely due to real estate holdings), but their cash flow is upside down every month. I'd make the arguement that you can calculate a straight net worth and then a liquid net worth to show what could be converted to cash quickly.

    From a statistical standpoint, capturing one net worth at one moment in time doesn't carry much weight for me. I'd rather see months and years of data on that to develop a trendline. A roller coaster-esque net worth trend would tell me a lot.

    I tend toward Tom Stanley's calculation on one's ability to accumulate wealth, rather than the net worth figure. In working on The Millionaire Next Door, he determined a formula that includes income, age, and projects whether you're an underaccumulator, average accumulator, or prodigious accumulator of wealth given those variables.

    Thanks for starting this discussion – it helps to challenge our status quo personal financial metrics.

  • Net worth in itself is indeed not that significant, but it is still important to check it, because (1) you can follow your progress, (2) you can make sure you have the right amount of insurance, and (3) you can determine what it takes for you to reach your financial goals. So, net worth in relation to other areas of personal finance is a very important exercise.

  • I certainly agree with this approach to looking at networth. It's an interesting number, but not something that is worth putting a lot of weight on.

  • Steve,

    I agree and disagree with your assessement about net worth. I agree with you that any number (net worth included) without context is absolutely worthless. That seems to be the crux of your post. Taking your Net Worth is like taking your blood pressure. Is it bad compared to other people (ie. normal averages), high for your body type, etc. Are there other stats you could take (cholesterol levels, blood/mineral composition, etc.) which can give you better indication of your overall health? Yes.

    This is where I disagree with your arguement, that used consistantly, net worth can give you a general overview of your financial health. Yes there can be better numbers with lots of inputs, but net worth is really a good indicator if you take it in context. Lets go through your points.

    #1 You don't know how it is calculated. Who cares? If it is calculated consistantly over time, then from a historical perspective and any meaningful statistical analysis, it is accurate. Where this becomes an issue, is when you compare net worth's between individuals who do not utilize the same methodology. This is true, but if you are keeping up with the Jonses, then you have bigger issues from a personal finance issue.

    #2 True the value of your money goes further in other locations, however, it does not matter when just comparing what a snapshot of your value is at that point. Yes it does not provide context to how far your money will go, but it is still a relative number that can be plotted on a line chart.

    #3 True, it does not show cash flow generation. Again so what? You are looking at a specific timeframe what your overall wealth is. You are not trying to figure out the complex formula of if you can retire at 45 or 55 depending on todays numbers which will happen in 20 or 30 years. It is like batting average versus box score (to draw a baseball analogy). Net worth is what you did that night (3 for 4). The magical number you are looking for is something like seasonal batting average (you know like .341 for the season/career).

    #4 True, again, you can never be defined in risk. How do I know what risk I have in my portfolio? I have a historical risk, but not future risk. How do I define what risk I should have in my portfolio? I never know the next Greece to collapse the international market while small caps go off like gang busters. I never know that so if you are diversified, why worry? You are doing the best you can to limit the risk you have while maximizing your potential upside. That is the inate risk of investment, and why financial advisors get paid the big bucks.

    Again, overall I think there is flaws in using the number, which you pointed out. However at the end of the day, if you take the numbers you derive consistantly, and plot them out over time, you will get a good overall look at how much money you have. That is all it is providing, how much money you have to your name. Not cashflow (look at a bank statement and your budget), not how much you need to retire, how far your money will go where you live, how long until you retire, etc.

    Now if you want to build the “super Steve number”, I will be glad to work with you on a consulting basis to create this 🙂

    • @big-d: All of your counterarguments are good. I originally got the idea for this post when reading an anonymous personal finance blogger's net worth update. His net worth was up 10% or whatever from the month before, and other than a minor breakout of retirement versus non-retirement savings he didn't really give any further context: age, location, family situation, career (in a growing industry, dying, etc.) and I realized that net worth, in and of itself, meant nothing.

      I have the ability using Yodlee to calculate my net worth to within a tiny percentage of error (for non-linked accounts). So I can find out what it is, compare it to previous month, previous year, etc. But to me, as I said to Mr. TML, my other habits and practices are far more important than worrying if (for example) my IRA is up 3% when my investing strategy (broad-based index funds) is largely determined by macroeconomic factors out of my control. Just my opinion! 🙂

  • Net worth is an important number but it is only one number involved in a complete overview of financial performance.

    There are three (or four, depending on who you talk to) fundamental statements used at every corporation that encompass the total financial health of the corporation. Regular individuals would do well to take notice of these and produce the same reports in their own accounting system.

    Basically, the balance sheet is what you have and what you owe, the difference is AKA your net worth.
    The Income statement details how much you profited or lost.
    The Cash Flows statement basically tells you how able you are to pay your bills.

    Wikipedia has a great breakdown of them: http://en.wikipedia.org/wiki/Financial_statements

  • “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.”

    I can agree to this with some extent, knowing your networth doesn't equate to happiness either, which I think plays a big role in financial health. Having a lot of money but being unhappy is almost the same as being extremely stressed out due to a large amount of debt. Neither of those emotions are good for YOUR bottom line.

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