Tuesday, March 13, 2007

Net Worth Is NOT Wealth: How to Determine Your Total Measure of Wealth

Author: Nick
Category: Money

your total measure of wealth

Yesterday I rocked the personal finance world by claiming that net worth is a poor measure of wealth. The classic net worth calculation of assets minus liabilities simply omits too much important information to provide a useful picture of your financial situation.

A lot of people like calculating their net worth, watching it grow, and feeling a sense of accomplishment if it goes up by a certain amount. I wouldn’t dream of robbing anyone of this pleasure, but I would like to propose a more complete set of criteria from which you can determine your Total Measure of Wealth™. (What, did you think I was kidding about turning this into a book deal eventually?)

The Keys to Your Total Measure of Wealth

To start putting together a complete measurement of your wealth, let’s come up with a list of all the aspects of your life that have some sort of bearing on your financial status. Here are the ones I came up with off the top of my head:

  • Net worth. Alone, net worth provides only a small fraction of your complete wealth picture. But that assets minus liabilities figure does give you a useful starting point for your calculations.
  • Income. Which would you rather have: a net worth of $100,000 with an income of zero or a net worth of $20,000 with an annual income of $100,000? Just looking at the net worth figure, you’d think the first case is better than the second. Then you throw in the incomes and suddenly you might be comparing somebody who’s unemployed to someone with a six-figure job.
  • Job status. Even income isn’t enough to give a full picture of your employment situation. Do you like your job? Will you still have it in six months? If you lost your job tomorrow, could you find a comparable one quickly? You might have a high salary, but if you hate what you do, your boss doesn’t like you, there’s little room for growth, and no other company is hiring for your position, then you’re on financially shaky ground.
  • Personal savings rate. The U.S. personal savings rate fell below 0% last year which means Americans are spending more than they earn. How much of your paycheck do you save? A positive net worth means nothing if it’s accompanied by a negative savings rate–well, except that you’ll be broke sometime in the future.
  • Rate of return (ROR). Which is more money: $500,000 with an annual ROR of 10% or $1 million sitting under a mattress? Your answer will be different today than it will be ten years from now. A high net worth is great, but an increasing net worth is even better.
  • Housing status. I’m a big proponent of owning your own home as a cornerstone of building wealth, but there are plenty of homeowners out there who are worse off than renters. Maybe you bought at the peak of the housing market in a “bubble” city, and now your house is worth 30% less than you paid for it. Or perhaps you have one of those fancy mortgages where you never pay a dime toward the principle. In these cases, a renter with a good job and money in the bank might be in a better financial situation than you.
  • Family status. A $50,000-a-year income goes a lot further if you’re single and without kids than if you’re married with six children. Determining how many people count on you for their financial well-being is a vital aspect of a true wealth calculation.
  • Self-reliance. You may have few people depending on you bringing home the bacon, but how many people do you rely on for your livelihood? Furthermore, do you rely on just one person or entity for your entire livelihood? Things that help make you more self-reliant: being self-employed, growing some or all of your own food, or diversifying your income sources.
  • Locale. I think it goes without saying that a dollar will get you more in Atlanta than it will in Beverly Hills. But there are other factors to consider than just cost of living. What sort of services does your local, state, or national government provide? How much do you pay in taxes? What are the bankruptcy laws like? At what rate is real estate appreciating in your neighborhood? How oppressive has your local warlord been lately?
  • Age. $100,000 in the bank does a lot more for a 30-year-old than it does for someone nearing retirement age. Throwing age into the wealth equation is a great way to ensure that worth calculations can be used by anyone, young or old.
  • Financial education. Here’s one key to wealth that few ever consider, but it can have a huge impact on what you do with your money. Even a moderate level of financial education (e.g. you read Punny Money frequently) can set you apart from those who were brought up to spend every penny they make. You wouldn’t need an MBA to score high here–just a basic understanding of concepts like credit, investing, the economy, and similar topics.
  • Health. Unless you’re fantastically rich and legally dubious, you can’t buy good health. Then again, all the money in the world can’t undo a lifetime of poor health choices. And while certain health issues are hard to prevent, being prepared with adequate insurance can go a long way toward financial stability.
  • Credit. This one should be easy to figure out thanks to credit scores, right? Maybe not as easy as you think. Which credit scoring scale do you use? How would you apply the score to your wealth measurement? And how do you account for things a credit score doesn’t consider, like cases where your score reflects that you messed up years ago with some unpaid bills but you have since committed to a life of financial harmony?
  • Personal outlook. Remember our hypothetical dictator friend from yesterday’s episode of Which Person Is Richer? He may be filthy rich, but he probably isn’t enjoying a life of looking over his shoulder, waiting for an assassin’s bullet. As many a celebrity can tell you, a life of fame and fortune doesn’t guarantee a life of happiness. And I know plenty of people who absolutely love their lives yet they live paycheck to paycheck. Your personal outlook, your financial aspirations, your dreams for the future–these things give your life meaning and direction and are a crucial part of your fiscal picture.

If you can think of any other criteria that should be on this list, please leave a comment with a quick explanation and the best ones will join this list.

Putting a Number on Your Total Measure of Wealth

It wouldn’t really be a measure if there weren’t some kind of number that came out of doing it. Net worth, income, and age are all straightforward to compute; but how do we enumerate things like family, health, and personal outlook?

Putting a number of these things is actually easier than you might think. Corporations assign numbers to you for these and other parts of your life all the time. For example, if you apply for a life insurance policy, the underwriter will examine your medical history and come up with a score that represents the likelihood that you’ll live long enough to be profitable to the company. These “scores” might not be as trivial to calculate as net worth, but isn’t a little extra work worth the reward of getting a complete picture of your finances?

In coming weeks, we’ll start looking at the keys above individually and come up with a mathematical formula for calculating your Total Measure of Wealth.

Monday, March 12, 2007

Why Net Worth Is A Poor Measure of Wealth

Author: Nick
Category: Money

Abacus by michelini - sxc.hu/profile/michelini

Ask any person with a modest level of financial education the question “How wealthy am I?” and you should expect the following question in return: “What’s your net worth?” That’s because net worth is the most commonly recognized measure of wealth. And it’s perhaps the easiest the calculate:

Net worth = Sum of all assets – Sum of all liabilities

It seems to work pretty well, too; few would argue that a person with a net worth of $327 million isn’t wealthy, and just about everybody would have a hard time applying the same label to a person with $100,000 in credit card debt and not a penny in the bank. Since the invention of money thousands of years ago, net worth has been seen as an accurate way to determine if a person is rich, poor, or somewhere in between.

How dare I pose such a headline to this article when even the IRS sees fit to use net worth as the measure of wealth? My reasoning for claiming that net worth is a lousy way to determine your wealth is simple: money is only a small part of one’s total wealth picture.

Let that soak in for a minute. Okay, a minute’s up. Time to shock the daylights out of you rich people: having a high net worth does not make you wealthy. Oh, and I have some good news for you low net worth types: having a low net worth does not make you poor.

I’ll give you some examples of what I mean when we play America’s fastest growing wealth-analysis game show…

which person is richer?

Let’s learn a bit about today’s first two contestants on Which Person Is Richer?:

  • contestant 1 - single motherContestant #1 is a single mother working two jobs and going to nursing school part time. She’s ridden with credit card debt, but she’s working hard and has a plan that’s put her on track to be debt free in just a few years. Net worth: -$33,000.
  • contestant 2 - poor boy from burundiContestant #2 hails from Ngozi, Burundi, considered by many to be the poorest country in the world. He has no home, no job, and he often doesn’t know when he’ll get his next meal. But at least he’s debt-free! Net worth: 25 cents.

Now it’s time to see how our studio audience voted when we asked them which of our two contestants is the richer person:

which person is richer? contestant 1 - 91, contestant 2 - 9

Aw, that’s a shame. I guess you can’t be richer than anyone when you don’t have two sticks to rub together. What do we have for today’s winner, Johnny?

Today’s winner will go home with a lifetime supply of rice! Rice–it may be tiny, but it can keep you from starving to death!

Thanks, Johnny. I’m sure our contestant from Burundi could’ve really used that rice, too. Oh well! Let’s meet our next two contestants:

  • contestant 1 - dictatorContestant #1 is a multi-millionaire dictator of a small Central American nation. Most of his family has been killed in assassinations or rebellion attempts. Now he’s fleeing for his life, spending every night in a different Motel 6 to hide from his enemies. Net worth: $85 million.
  • contestant 2 - family manContestant #2 is an upper middle class American family man. He’ll be turning 40 next month, he has $100,000 in the bank saved for his kids’ college, and his 401(k) just hit $300,000. He’s in perfect health, and he loves his life! Net worth: $520,000.

Wow, that’s quite a life you’ve been living there, Contestant #1. Let’s hope you make it out of our studio alive! And speaking of studio, we asked our studio audience to decide which of these two contestants is richer, and here’s what they said:

which person is richer? contestant 1 - 17, contestant 2 - 83

Ouch! Looks like having millions of bucks can’t buy happiness for poor Contestant #1. What do we have for Contestant #2, Johnny?

It’s a free session of plastic surgery! Whether you want to look ten years younger or just hide from the people trying to kill you, this plastic surgery is sure to change the way you “face” the world.

Ha ha ha! Looks like that’s all the time we have today on Which Person Is Richer? Tune in next time when we find out who’s richer: a hunchbacked circus clown or MC Hammer.

Hopefully you get my point by now.

Certainly these are atypical cases, but they are instances where the net worth model of wealth determination completely falls apart. If using net worth to compute richness fails so badly some of the time, it’s reasonable to assume that it might have some shortcomings for the rest of us.

Tomorrow we’ll look at my proposal for a more appropriate assessment of one’s financial status that I like to call the Total Measure of Wealth™.

(Trademarked for when I score a book deal out of this.)