If you spend any time at all learning about personal finance, you’ll quickly hear the advice to focus on net worth instead of income. Net worth, we’re told, is the true indicator of wealth. I mean, hey, just last week I wrote about the importance of net worth in bringing you closer to what I consider to be the top two financial goals: security and freedom. So it’s got to be a pretty telling number, right?
It is. Of the traditional financial indicators, net worth is the best one at describing a person’s true level of wealth. But it’s not without its flaws, and there are plenty of circumstances where a person’s net worth is misleading. Here are some of the things to consider before making any conclusions about your net worth.
It’s a snapshot in time
Your net worth is a record of your assets and liabilities at a single point in time. No matter when you measure it, the point in time is arbitrary and the value of your assets may be up or down through no fault of your own.
If you have money in the stock market, your net worth will look much different today than it did in 2008, even if you hadn’t made any contributions or withdrawals. Housing prices have had similar wild fluctuations, leaving you with different levels of measured wealth at different points in time.
Net worth is just a number and does nothing to explain the environment in which it’s being measured. Given that you can’t control the ups and downs of the market, your current net worth is partially the result of factors over which you have no influence. Even if you do nothing, it will undoubtedly be different in the near future.
It doesn’t account for the types of assets and liabilities
If you’re working towards financial freedom, whether in the form of a traditional retirement or an early one, net worth is a much better indicator of your progress than income. But it still has a significant weakness in that it loses the details of your specific assets and liabilities, and those details can make a big difference in understanding your future prospects.
Let’s imagine two people with a net worth of $500,000. Pretty impressive right? One of those people owns a home worth $450,000 and has $50,000 in savings/investments. The other owns a home worth $200,000 and has $300,000 in savings/investments. They both have the same net worth, but which one is in a better position to secure their freedom sooner?
All other things being equal, it’s the person with $300,000 in savings and investments. That’s money that can earn you more money (read my article on how to beat 80% of investors with 1% of the effort). It’s also money you can spend. Owning a home has many potential benefits, but it is not earning you money (I’m talking about a primary residence here. Rental properties would fall in the “savings/investment” category.) It’s actually costing you money through taxes, insurance, maintenance and the like, and a more expensive home likely has higher costs. And in addition, your home’s value is not money you can spend, unless you’re willing to either put yourself further into debt with a line of credit or to sell and downgrade to a less expensive house. So the types of assets you own have a significant impact on both their future growth and your ability to actually use the wealth they represent.
On the other side of the equation, the details of your liabilities matter a lot as well. $100,000 of debt counts the same in your net worth no matter where it came from. But would you rather have a $100,000 mortgage at a 4% interest rate or $100,000 of credit card debt with a 15% interest rate? The choice here is clear, but this kind of nuance is not reflected anywhere in your single net worth number.
It doesn’t factor in how you’re adding to it
Just as the types of assets you own dictate their chances for future growth, your own actions have a significant role in growing your net worth as well. I would rather have a $0 net worth but be able to add $25,000 per year to my savings and investments than a $100,000 net worth I couldn’t add to. This is where the dual principles of frugality and earning more come into play. If you want to build wealth, you have to live below your means. And the further below your means you live, the faster your wealth can grow. If you want to accelerate things, your options are either spending less or earning more, or even better a combination of the two. But in any case, increasing the amount you can save is the surest path to wealth generation, and it’s one that is not seen anywhere in a statement of net worth.
Net worth is an important indicator when it comes to measuring your progress towards both financial security and freedom. But it’s just a single number, and there are many variables to consider alongside it if you’re truly trying to gauge your financial position. Make sure you account for the entire picture when planning your family’s future.