Making Sense of Your Net Worth
Hardly a week goes by where the term “net worth” doesn’t pop into a conversation, advertisement, or other media. Despite its prevalence, however, understanding how to track it or calculate it and why, in some ways, it can be more important to one’s financial health than watching the balance of an investment account, is often unclear. Additionally, the term “net worth” can sometimes elicit a negative bias; perhaps because of an aversion to the idea that a simple number can measure a life’s work. As financial planners, we believe there is value in measuring this financial number, understanding its components, and leveraging it to support the life of your dreams.
Defining Net Worth
Peter Drucker, one of the 20th century’s foremost leaders in management consulting, famously said, “If you can’t measure it, you can’t improve it.” When thinking about one’s net worth, we think the same mentality applies; tracking net worth is one of the best ways to gain clarity and insight into an individual’s financial health. And this is one of the reasons why we like to show our Clients a snapshot of their net worth during annual update meetings. Calculating one’s net worth requires adding up the value of all one’s assets and all one’s liabilities. Then, the formula is simple: subtract your total liabilities from your total assets, and the remaining amount is your net worth. The lists below share examples of assets and liabilities to keep in mind for each calculation.
Where to Focus: Account Balances or Net Worth?
It’s easy to get caught up in the day-to-day ebb and flow of the stock market news. After all, the financial media is a billion dollar industry designed to keep us glued to every single market gyration while exposing us to unrelenting advertising. Supposed “experts” provide off-the-cuff financial advice while discerning the latest market action through the lens of the “headline of the day”. All this “news” causes us to focus heavily on our investment account balances, leading us to measure our wealth or success by how well our investment accounts performed on a daily, weekly, monthly, and yearly basis. The result of this self-assessment is usually a feeling that our financial life is on a never-ending financial roller coaster. The problem with this approach is that it’s impossible to discern any meaningful pattern from the daily or even monthly movements of a portfolio weighted toward stocks. By focusing our attention solely towards investment account statements, it becomes easy to ignore the other components of a net worth statement that are in some ways more crucial to building long-term wealth.
Seeing the Forest Among the Trees
When we shift our attention from tracking our account balances to tracking our net worth, beautiful things happen. Have you ever been working on project or problem where you’ve found yourself focusing so much on the details that you forget to see how the various elements fit into the larger picture of what is going on? I have done this many times. In fact, I expect this to happen when I am working on complex projects. What I’ve learned is that oftentimes, all I need to do is walk away from the problem and come back with a new perspective to be able to work through the issue in a new, more constructive light.
Tracking your net worth serves a very similar function. Stepping back from the singular focus on building wealth by monitoring our investment accounts helps us make the cognitive shift to seeing our investment accounts as one element of a broader wealth building strategy. We become less emotional about the ups and downs of a portfolio and can evaluate financial decisions with a more rational focus. With this broader perspective, we are better able to weather enviable market storms.
Making Sense of Your Net Worth
Tracking and understanding a personal net worth statement can provide a deeper level of financial knowledge. Consider the following three examples:
- Should you pay down debt or deploy funds to invest for the future?
- For an individual in the accumulation stages of wealth building, it is common to have assets such as employer-sponsored retirement plans, checking and savings accounts, and after-tax accounts, and liabilities that include student loan debt, high-interest credit debt, and auto loans. As such, they often face the question: should they pay down debt or deploy funds to invest for the future? When faced with this question, it can be beneficial to look at the net worth statement as a balanced mathematical equation with a goal of rearranging the terms of the equation to your benefit.
- For example, let’s say a person has $25,000 that they can either invest in a broadly diversified portfolio or pay down their $25,000 high-interest credit card debt. Which option makes more sense? When you understand how a net worth statement is constructed, the answer becomes clear that often times, it makes more sense to pay down the debt versus investing the funds. While it can feel like paying off the debt is a “loss” of funds, when looking at the bigger picture, you see that using a lump sum to pay off the high-interest rate debt produces a net gain of savings from not paying the cost of high-interest debt payments and increases real monthly cash flow.
- Is your home an asset or a liability?
- Another way tracking and understanding a personal net worth statement can provide a deeper level of financial knowledge is when an individual has a majority of their wealth locked into the value of their home. With the exponential growth in the housing market since 2008, many people’s homes are their most valuable asset. Often the value of this asset is locked away in home equity. This home equity is out of sight and sometimes out mind. By understanding one’s net worth statement, you’re able to see clearly how a home’s value fits within a person’s overall wealth portrait. Couple this understanding with the fact that reverse mortgages are becoming more transparent and regulated, the mathematical nature of a net worth statement makes it easier to shift one’s mindset to gain a new prospective on how one’s home’s equity could be used as a contingent resource to support retirement needs, long-term care costs, or unforeseen situations.
- Can you afford to take on more debt?
- Finally, the evaluation of whether one should take on debt, and its effect on the net worth statement, is critical to achieving financial success. Not all debt is created equal. Taking on high-interest credit card debt to fund a trip to Cancun is very different than taking on debt that is used to buy an asset that produces a stream of income or to increase skills through education. Tracking the presence of debt, its interest rate, and its purpose on a net worth statement provides context to one’s financial situation. Understanding that liabilities on the net worth statement may not necessarily be harmful to a person’s financial situation enables the individual to make informed choices about whether the acquisition of debt will lead to wealth creation or wealth reduction.
As you can see, there are a lot of benefits from viewing investment account balances as a part of a broader net worth statement. Of course, there are also complexities in this way of financial thinking. As financial planners, we think it’s vital to examine our Client’s net worth statements so we can better advise and assist Clients in reaching their financial goals. So next time you have a question about your net worth statement, or want to see how your investment accounts, debts, and other assets fit into your whole financial picture, contact us, and we’d be happy to discuss your individual situation.