Search Posts

Why Your Net Worth Isn’t the Most Important Number

Illustration for article titled Why Your Net Worth Isn’t the Most Important Number

Image: Pcess609 (Shutterstock)

In personal finance your net worth gets a lot of attention, and for good reason—it’s basically your financial report card. You can calculate your net worth—or statement of financial position—by subtracting your total debt from your total assets.

Some experts say another number could be a better measure of your finances. Nick Maggiulli, the chief operating officer for Ritholtz Wealth Management and blogger at Of Dollars and Data, argues your net worth doesn’t provide context for how you reached your current financial status.

While two net worths could be the same number, they may not be equal. For example, Maggiulli says there’s a big difference between someone who inherited most of their $1 million net worth and someone who saved and invested to achieve the same milestone.

The lifetime wealth ratio

Instead of focusing on your net worth, Maggiulli suggests looking at your lifetime wealth ratio, a concept from personal finance blogger J. Money of Budgets are Sexy.

Here’s how to calculate your lifetime wealth ratio:

Lifetime Wealth Ratio = Net Worth / Total Lifetime Income

As a reminder, you can calculate your net worth as follows:

Net Worth = Total Assets – Total Liabilities

You can see your total lifetime income through Social Security’s website. After creating an account and logging in, click on your Earnings Record in the right column. There’s a cap on Social Security earnings, so you should add up your taxed Medicare earnings (right column) to get your total lifetime income.

The next step is dividing your net worth by your total lifetime earnings. This percentage tells you how much of your income you have turned into wealth. J. Money uses the following rankings to gauge your progress:

  • 0%-10% – Meh
  • 10%-25% – Now we’re cooking!
  • 25-50% – You’re on fire, baby! Give me your number!
  • 50-100% – Marry me.
  • 100%-1,000% – How do I get into your will?

While the rankings may be far from scientific, Maggiulli argues it may be better than your net worth alone. The lifetime wealth ratio considers your ability to save and invest, but it’s far from perfect. The ratio may be skewed against younger folks who haven’t had much time for their assets to grow. It may also be biased against higher earners who may be saving—but also paying more in taxes.

The group that benefits the least from the ratio are those with consistent low income. It can be very difficult to save money and build wealth when you’re spending almost all your income to cover the basics.

The wealth discipline ratio

Based on the limitations above, the lifetime wealth ratio has some major flaws. To make up for these shortfalls, Maggiulli suggests using another number: the wealth discipline ratio. This is identical to the lifetime wealth ratio, but removes necessary spending each year.

Here’s the reasoning: everyone has to spend money on the basics. Maggiulli argues we should remove necessary spending from the ratio because you don’t have a chance to save or invest that money. He believes you should only count the money you could have saved and invested.

Here’s how to calculate the wealth discipline ratio:

Wealth Discipline Ratio = Net worth / (Total Lifetime Income – Basic Lifetime Spending)

It’s not easy to calculate your basic lifetime spending, but you may consider the annual base-level spending (rent, food, utilities, transportation, etc.) for your family in each city you have lived.

While there isn’t an ideal wealth discipline ratio, Maggiulli says the ratio may still offer some insights. For example, if you’re closer to the 10% ratio you may have room for improvement, and a 100% ratio may indicate you’re not spending enough.

Leave a Reply

Your email address will not be published. Required fields are marked *