Wednesday, November 11, 2009

How Tracking Net Worth can be Misleading

Net worth is a common measure used for tracking personal wealth. Net worth is the value obtained from summing all assets and subtracting all liabilities. Simply, net worth is equal to all belongings minus all debts.

When I was younger, I used net worth to measure my wealth accumulation. However, I as got older, I realized that net worth alone didn't provide enough perspective on readiness for retirement. For example, consider the three situations in the table below.

Net Worth Comparison
ExamplesAssetsLiabilitiesNet Worth
High Debt$5 million

$2 million

$3 million
Illiquid Assets$3 million (houses, land, yacht, etc.)$0$3 million
80% Liquid Assets$3 million ($600,000 in illiquid assets and the rest in stocks, bonds, and cash)$0$3 million

While all three have $3 million in net worth, the readiness for retirement situation is very different. In the high debt example, the person has a minimum debt payments of $140,000/year , assuming a 7% interest rate, before other living expenses. In the illiquid asset/no debt example, the assets likely have fixed maintenance costs and do not generate income. Assuming 2% maintenance costs, the person would need $60,000 per year. In the 80% liquid assets/no debt example, the investments are generating income, and the assets require less annual maintenance money (e.g. $12,000/year at 2%).

I came to this understanding back in 2006 and stopped using net worth as a measure of our wealth. As a replacement measure, I started using Savings Ratios and Debt Ratios, as explained in How Much is Needed to Be Wealthy - THE NUMBER .

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial, saving or retirement advice. Please consult a professional advisor.

Copyright © 2009 Achievement Catalyst, LLC

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