Few people really care about their Net Worth. They say "what I own does not define who I am, it's what I do with my time that counts". And we all agree.
But that doesn't mean you shouldn't care about your finances. There was a time when people would work in the same company their whole career and would retire without having to worry too much about having enough to live through their golden years.
That time is gone. Over. Even in the most "socialist" of the European countries, it's unlikely that anyone will be able to live comfortably during retirement on public funds alone. The truth is that we all have to start spending more time thinking about our money and our future because... no one else will do it for us.
Defining Net Worth
Let's start with what net worth means. Here's Investopedia's definition:
Net worth is the value the assets a person or corporation owns, minus the liabilities they owe.
In other words, it’s whatever cash balance you’d be left with if you sold all your assets and paid off all your debts... and yes, your net worth can be negative.
Your net worth may be composed of liquid or non-liquid assets, which basically refers to how quickly you can sell the assets. The faster an asset can be sold, the more liquid.
If you spoke to a Wealth Manager, they would probably ask you about your "liquid assets" which refers to all the cash, stocks (and other bonds, funds, etc) or cryptocurrencies you own. That's because if they take you on as a client, they'll invest (or "manage") your liquid assets and then take a yearly commission calculated on the total value of said assets.
Non-liquid assets are, on the other hand, of no interest to Wealth Managers, no matter how much you actually own in non-liquid assets. Examples of non-liquid assets could be real estate (including land), vehicles, boats, jewelry, art, wines, collectibles, etc.
Statistically, people tend to hold more non-liquid assets than liquid assets. There may be multiple reasons for this, one would be a very real fear of losing everything in the stock market. Another could be that people like to "see" their assets and houses, cars and jewelry are much more palpable than numbers on a screen.
The major downside of this however is that the stock market disproportionately profits to the rich. Look at the results of the 2016 Survey of Consumer Finances made by USA's Federal Reserve. The numbers are striking. Have you ever heard the phrase "the rich get richer"? Well, that's why. No matter how great your non-liquid assets are, it's unlikely their return on investment beats the stock market. If you're interested, we wrote another article that dives deeper on the topic and tries to answer the question:
Back to the composition of your net worth. On the opposite side of assets, there's debt. Someone's debt could be composed of revolving debt or term (or installment) debt. The major technical difference is that a revolving debt (for example credit card debt) will have no end date whereas a term debt will follow a predefined repayment schedule. If you have contracted a mortgage on your home for example, that is most likely a term debt.
It's important to differentiate your debt into these categories because revolving debts will usually cost an insane amount of money (their interest rates can go over 18%!) and you should try to avoid those as much as possible whereas term debt can have an incredibly positive impact on your wealth, when contracted carefully.
Tracking Your Net Worth
OK so we know what net worth means and how to calculate it. What's the point?
At some point in your life, you'll stop working and retire. As mentioned in the intro, you may not be able to rely solely on your government's payouts. That's why you should be aiming at building a nest egg while you have an income so that you can live as comfortably as possible when you don't. It's the most common objective for most people interested in their finances. As a rule of thumb, you should aim at retiring with (at least) 25 times the amount you'll be spending yearly during your retirement.
This is called the 4% rule and we have another article you can read if you want to know more. In short, it's a good rule of thumb, but not necessarily a universal rule, it depends a lot on your assets and many other factors.
Now reaching that objective, or any other financial objective for that matter, is not necessarily easy. It may require some adjusting of your spending and lifestyle. But how do you know how much you will be able to save by the time you're 60 or whenever you think you'll retire? That's where your current net worth comes in.
Your current net worth is the starting point of a somewhat complex formula that will allow you to calculate your future net worth. Of course you could simply multiply the amount you're able to save each year by the number of years you have left before your retirement. That might be a good quick estimate, but there are many factors to consider if you want to do this seriously:
- Inflation: the longer you have left before you retire, the more impact inflation will have (i.e. you will have to have saved more to live the same lifestyle);
- Return on investment of your investments: hopefully you don't just keep your savings under your mattress and you have invested your savings so that they grow with time;
- Future expenses and sources of revenue: have you factored in your kid's college tuition? Buying a house? Have you considered any future income you may expect in the future, including any government help, retirement funds, etc?
- Growth rate of your income and your saving capacity: you should be able to save more as your income grows.
By considering all these parameters, you should be able to forecast a good approximation of your future net worth and you should be able to compare that with your objectives.
If you don't want to spend too much time with this formula, you can create a Oakify account for free, Oakify will guide you through the setup, will ask a few questions and will calculate your future net worth automatically. A nice feature there is that it will calculate three scenarios, pessimistic, optimistic and realistic, so you can have a fairly coherent range of possible outcomes.
Once you have a good understanding of your future net worth, you get to figure how realistic your objectives are. Because life will keep throwing curve balls at you, your objectives may change and your progress may not be in a straight line, but that's OK! What's important is to keep an eye on your net worth, update it ideally once a month and see how your projections look. If you're missing the mark, you may need to change a few things in your life, spending patterns, etc, or maybe it's just a matter of changing the objective itself.
The key is to know if you are on track or not. Scientia potentia est (knowledge is power). When you know, you can react and try to make the right decisions. Maybe you will, maybe you won't, everyone makes mistakes. But one thing's for sure: you won't be able to react if you don't know.