If you want to figure out how wealthy you are, the advice you’ll likely receive is to calculate your net worth. At a very basic level, the formula you’re like to use probably looks something like this:
- Create a list of all assets (everything you own) and add up their value
- Create a list of all liabilities (everything you owe) and add the them to get your total debt obligation
- Subtract your liabilities from your assets
- Pray that the number that emerges is positive
Put another way Net Worth = Assets – Liabilities.
If this is the calculation you’re using to determine your financial health, you may be surprised to learn that the number you’re coming up with isn’t the best way to measure real wealth.
Why Your Calculation Is Likely Flawed
When most people use the aforementioned process to calculate their net worth, they’re likely going to come up with a number that paints a picture far more positive than reality. It has everything to do with how the first step is calculated. The problem arises from what you’re probably being quick to label as an asset.
Assets
Ask your friends, family or any random person to list their assets. Most will respond with things like the “equity in my house, my car, savings, 401k balance, and other investments”. That list likely reflects the types of items you’ve likely been told are good representations of an asset. Some I would agree with. Others, not so much. Take your personal home and car as examples.
The value of your home and car are largely subjective. The tools at websites like Zillow and Autotrader are what most people use to determine the value of their home and/or car. Despite what the websites say, the only time you truly learn what those items are worth is when you try to sell them. Even if you could accurately know what your personal home and car are worth, I still wouldn’t consider them assets.
This has to do with the true definition of an asset. I reserve the label of asset for things that put money in my pocket on a regular basis. In simple terms, an asset is an instrument that produces income that can be used for life’s expenses or to grow your net worth. Examples of assets include dividend-paying stocks, bonds, index funds, profitable businesses and rental property. They all regularly produce income for the owner.
If we try to add our personal home or car to that list we see that they don’t fit. Unless you’re renting a portion of your home or driving for Uber/Lyft, they don’t produce income. Truth be known, they cost you money in the form of maintenance, taxes and insurance. At best these items would be considered neutral.
Liabilities
Most people don’t have trouble identifying the liabilities in their life. I sure don’t. All it takes is a quick look at your bank statement to identify the liabilities. A simple definition is anything regularly costs you money outside of food, clothing and basic shelter.
Common examples could include, credit card debt, your mortgage, student loans, auto loans and maintenance costs. They all consume capital and offer little to no consistent financial return. With the basic definitions out of the way, let’s look at two ways of calculating net worth – augmented net worth and liquid net worth.
We’ll quickly discuss each of them. I’ll leave it as an exercise for you to decide on which method you prefer.
Asset vs. Liabilities Discussion
Augmented Net Worth
What most people label as their net worth would be better called “augmented net worth”. This term was first coined by the late author Thomas Stanley in his book Stop Acting Rich: And Start Living Like a Real Millionaire. Augmented net worth is the result of including things like the equity in your home, the estimated value of your car, fine art, and watches in the asset column of your net worth calculation.
Let’s take a look at what that could look like. Our old friend Nathan Normspend is back. This time he’s calculating his net worth.
What most people label as their net worth would be better called “augmented net worth”.
Augmented Net Worth Calculation
ASSETS
- Home Value: $350,000
- Car: $12,000
- 401(k): $20,000
- Brokerage Account: $16,000
- Savings: $3,000
Total Assets: $401,000
LIABILITIES
- Credit cards: $2,000
- Student loans: $33,000
- Auto Loan: $8,000
- Mortgage: $225,000
Total Liabilities: $268,000
Nathan’s Augmented Net Worth: $401,000 – $268,000 = $133,000
Nathan’s net worth calculation is representative of how most people would probably do it. It looks great on paper. Let’s stress test this number and see how well it stands up to reality. For a moment, let’s assume that Nathan becomes unemployed. He still has the same liabilities. In this situation, which entries in the asset column are going to feed him?
Assuming he’s over age 59 ½, only three of his five “assets” are going to put money in his pocket to pay expenses. He could count on interest from his savings account and the dividend income produced by the securities in his brokerage and 401(k) accounts.
Nathan is quickly realizing that what he thought was his wealth is nothing of the sort. His home and car aren’t helping his predicament. In fact, he’d probably be better off without them in this stage of the game.
If the augmented calculation doesn’t pass muster, how do we measure his true wealth?
Liquid Net Worth – A Better Measurement of Wealth
A more accurate measurement of Nathan’s wealth would be to calculate his liquid net worth. Let’s see what that would look like. An easy way to think about liquid net worth is ask yourself, how much cash you could easily get your hands on in less than one week. The thinking behind this is to perform the calculation as if you needed money for an emergency. Let’s see what that could look like.
ASSETS
- Home Value: $350,000
- Car: $12,000
- 401(k): $20,000
- Brokerage Account: $16,000
- Savings: $3,000
Total Assets: $39,000
LIABILITIES
- Credit cards: $2,000
- Student loans: $33,000
- Auto Loan: $8,000
- Mortgage: $225,000
Total Liabilities: $268,000
Nathan’s Liquid Net Worth: $39,000 – $268,000 = $-229,000
Instead of having a $133,000 cushion, reality shows that Nathan is really $229,000 in the negative. Ouch. As painful as this version of his net worth is to look at, it better reflects his financial health. It’s a more conservative and realistic way to calculate his net worth as a measurement of true wealth.
Some of you will point out that Nathan could have sold his home to come up with additional capital. And you’d be right. He could do that. Likely he would have had sell it at a discount given the immediate need for cash. Thus, only a percentage of his home value could be added back.
The fact remains though that he would need somewhere to live. So, unless he’s planning on living for free with friends or family, that money is eventually going to be consumed.
Additionally, if Nathan is under 59 ½, he would not get to use the whole amount that he has in his 401K due to a 10% early withdrawal penalty. As you can see, things get complicated when calculating net worth of any kind!
More Important Than Net Worth
Most of us have been told the myth that your home is your largest asset. The fact of the matter is your home costs money and in times of economic hardship, you might wish you didn’t have it. Ask yourself were you to stop working today, how long could you survive.
I’m not saying that a house is a bad place to put money. It just shouldn’t be considered an asset for most people. The same holds true for items like cars, watches and art work.
Focus on Creating Investment Income
What Nathan’s example highlights is the importance of focusing on buying income-producing assets. Your personal residence is the last place that you’d want to have the majority of your net worth. Instead of your home, it’s wiser to build up your portfolio of assets that will actually pay you.
I’m personally a fan of dividend-paying stocks and index funds but do whatever floats your boat. Rental property and growing a successful business are also great avenues for increasing your investment income. If the income regularly produced from your assets perpetually exceeds your liabilities then by definition you are wealthy. Congrats!
The numbers really don’t matter. You could own assets producing just $60,000 per year and be wealthier than someone earning much more. As long as that $60,000 more than covers all your expenses throughout the year, then you are wealthy.
Granted you may not live the lifestyle most think about when the idea of a wealthy person comes to mind but that part is unimportant. By focusing on creating investment income, you’ll build a financial position that’s truly strong.
Don’t Get Caught Skinny Dipping
At some point in your life, it’s very likely that you’ll experience a situation that puts a strain on your income from a job. It could be an illness, getting laid off or the entire company going away due to shifts in the economy. To quote Warren Buffett – “only when the tide goes out do you discover who has been swimming naked“.
When an adverse financial event comes your way, a diversified income-producing investment portfolio will serve you well. It doesn’t take a lot of money to get started. When it comes to successful investing, consistency and patience are among the most important traits to develop. Your future self will thank you.
"Only when the tide goes out do you discover who has been swimming naked."
Minimize Expenses
While we’re out there grinding to grow income-producing assets don’t forget the liability side of the equation. Just like a healthy diet combined with regular exercise is a great formula for reducing weight, reducing expenses is an important way to quickly accelerate your net worth. It’s best to tackle the problem from both ends. You’ll be amazed at what a few years of consistent effort can do.
Tracking Your Progress
On this journey towards increasing your liquid net worth, it’s helpful to use tools to track your progress. There are tons of options ranging from a spreadsheet to free wealth management software. The tool I personally use is called Personal Capital. It’s completely free, does a great job and has several trackers and calculators that are useful for managing your finances.
Tying it Together
The augmented net worth calculation certainly feels better which is probably why it’s more commonly used. As we saw in Nathan’s case, this method very well might leave you hanging during economically stressful times.
What do you think about the idea of using liquid net worth instead of augmented net worth as a true measurement of wealth? Had you heard of the term augmented net worth before reading this? Let me know in the comments below!
A great FREE tool I personally use for tracking my portfolio is Personal Capital. When you click this link to sign up for your free account, both you and I will receive $20. Every little bit helps right?
This Post Has 2 Comments
Cash flow is what matters. It’s what people feel everyday… but most people are weak willed
You make a good point LJ. Regular cash in your bank account matters more than a huge arbitrary number.