Wealth is different from income.
I’ve seen many people confuse this, including the media.
You can have a high income and a low net worth or a moderate income and a high net worth.
Net worth generates freedom. First, wealth held in investments generates passive income. That’s nice. Second, it amplifies your influence on the world (good or bad).
For most people, net worth depends more on your saving and investing behaviours than it does on your income.
Consistent saving and investing make use of the compound, ballooning net worth over time.
What is Net Worth?
Net-worth is your measure of financial wealth. It is the difference between what you own and what you owe.
Net Worth = Total Assets (what you own) – Total Liabilities (what you owe)
What is an Asset?
An asset is anything that can be sold for value. Assets add to your net worth. Examples include stocks, your home or your car.
Even your cat is an asset. Yes, Mr. Whiskers can be sold for money. (I’m not advising that you sell Mr. Whiskers).
Some assets go down in value over time (depreciate), while others go up in value (appreciate).
In addition, some assets pay you cash (dividends), and some take money away from you. This flow of payments is called cash flow.
We will discuss asset types below. The net worth grows when you buy assets that:
- Go up in value over time; and
- Pay you cash flow.
What is a Liability?
A liability is something that you owe. Debt. Examples include:
- Student loan.
- Auto loan.
- Line of credit.
- A credit card balance.
Liabilities subtract from your net worth. In addition, they generate a negative cash flow because you need to pay interest on the loan.
Why Is Net Worth Important?
The goal to reach a specific dollar value of net worth is meaningless without a deeper reason behind the goal. A high net worth number won’t bring you happiness or well-being alone, especially if the goal is to have a bigger number than the next guy or girl.
Net worth is only important if it has an underlying purpose. Let’s go into a few of these reasons that give net worth importance.
1. A Measure of Financial Health
Net worth is a measure of financial health. Positive net worth means you are free from the shackles of debt … kind of.
It’s not a perfect measurement of freedom from money stress and anxiety. You can have a positive net worth and still be living paycheck to paycheck. This happens when your assets are difficult to sell (illiquid) like home equity.
You have a positive net worth if you have money in your pocket after selling everything you own (your assets) and paying off all your debts (liabilities).
2. Provides Time Freedom
Net worth that is located in investment assets can generate rental and dividend income without placing demands on your time. This is called “passive income” – an overhyped term.
For example, many businesses owned via stock will pay you cash dividends. Similarly, rental properties with a good property manager will result in a monthly income without any demands on your time.
Newly available time can be used to improve your non-monetary forms of wealth. Here are a few ways you can use your time to improve wellbeing:
- Further your knowledge and skills.
- Improve your health and fitness.
- Improve relationships with others.
- Engage your skills to improve the world and produce meaning.
Learn more about wellbeing in the Ultimate Guide on Money, Happiness and Wellbeing.
3. Expand Your Sphere of Influence
Let’s say you want to expand access to clean drinking water. You could travel to communities with your lonely self and set up reverse osmosis machines.
Or, you could hire a team of 100 personnel to hit 10 communities at the same time. Your wealth allowed you to touch more lives.
A high net worth amplifies your ability to influence the world. Money allows you to buy businesses, give to charity, or hire others to further your unique purpose.
Net worth can only amplify what already exists. A strong purpose throughout the journey of growing wealth is important. Lets not underplay that there are plenty of ways to expand your sphere of influence with little to no money – start a blog for example.
4. Can Give Your Financial Life Direction
There are two things you need to know to have a sense of direction:
- Where you are.
- Where you want to go.
Net worth is a measure of where you are financially. Now you can define where you want to be in the future. I’ll assume you want to grow net worth….
Next, you can figure out how to get to the place you want to go. Perhaps you learn how to control spending, pay down debt, build an emergency fund. Then you start learning about investment assets.
Where you are going is more important than where you are. Life is complex – compare yourself to your old self rather than others.
Want to make good money decisions, but never learned how?
Access the resources that taught me about personal finance.
Net Worth Location: 3 Asset Types
Assets are the positive portion of your net worth. It is helpful to view assets through the lens of cashflow and appreciation/depreciation.
Cashflow: Does the asset pay you on a periodic bases? Or do you need to make payments to keep the asset?
Increase/Decrease in Value: Does the asset go up in value or down in value over time?
“Use assets” are items that you “use”. I feel like captain obvious.
Your house (the structure), electronics, boats, books, and furniture are examples of use assets.
These assets go down in value (depreciate) over time. You need to spend on maintenance to upkeep these assets. Maintenance costs are a negative cash flow.
Oftentimes, your maintenance efforts won’t be enough to prevent depreciation. Your vehicle is an example. It declines in value even while you maintain it.
I cover more on vehicle depreciation in this post.
Your Home As a Use Asset
You may be saying: “My home is not a use asset. It’s an investment asset – you dummy”.
I feel you, but a home is not an investment. The land your home sits on goes up in value (appreciation), but it also generates a negative cash flow due to property tax.
The structure of your home is certainly a use asset. It goes down in value over time and generates a negative cashflow as you pay for maintenance and updates to keep it recent.
Your home is only an investment asset if you rent it to others to generate cash flow. I dig into the costs of homeownership in this post on the rent vs buy decision.
Investment assets appreciate and generate positive cash flow. These assets are the engine that can grow wealth over time.
Investment assets are productive. They appreciate and generate (or are expected to generate) cash flow.
Bonds do not appreciate (unless interest rates go down), but they do generate cash flow. With today’s low rates, bond cash flow barely keeps up with inflation.
Examples of Investment Assets:
- Business Ownership (Stocks): A stock is a portion of a business. By owning a business (stock), you get to share in the growth of the business. Many businesses will pay you a share of the profits in the form of a cash dividend. You can invest in stocks via index funds.
- Cash flowing Real-Estate. When you own real estate as a landlord you get to share in the increase in value of the land and the cash flow produced by renters (tenants).
- A bond is a method to loan your money to others. The individual who receives the loan then pays you interest payment. Bonds do not appreciate (simple case).
Monetary assets, like cash, hold value in the short term and are easily accessible. These assets are “stable” and “liquid”.
Stability and liquidity are great for savings that you need to access in 5 years or less. A wedding or a downpayment on a house are examples.
Examples of Monetary Assets
- Physical Cash
- Cash in a Savings Account
- Cash in a Chequings Account
- Money in a Money Market Fund
Monetary Assets and Inflation
Monetary assets are “safe” in the short term, but risky in the long term. Inflation is the reason – it erodes the purchasing power of cash.
Let’s assume that you have $1,000,000 in cash hidden in your underwear drawer. You don’t add to the stash of cash, nor do you draw from it. It sits there.
The numerical value of your net worth stays the same day to day. But inflation silently eats away at the purchasing power of your net worth. You are losing $27,000 each year based on the historical average inflation rate of 2.7% in the US.
At the time of writing, U.S. inflation came in at 7%. That means the $1,000,000 of cash lost $70,000 in purchasing power in 2021 alone.
Asset Types: A Summary
- Investment assets go up in value and pay you cash flow. They increase your net worth. Examples include stocks, bonds, and cash flowing real estate.
- Monetary assets (cash) are stable, liquid, and generate zero cash flow. They lose value to inflation over the long term, but are great for short term savings (<5 years).
- Use assets go down in value (depreciate). You often need to pay money to maintain these assets (a negative cashflow).
The Direction of Your Net Worth
Is your net worth growing or declining? That depends on two factors:
- How much you add to your net worth, based on your income and savings rate.
- The type of assets you own.
Let’s assume you are not actively adding to your net worth or removing from your net worth. You’re net worth neutral.
Now I give you $100,000. The pretty graph to the right shows three different ways that you can use the $100k.
The different trajectories show the power of choice. What you do with your income matters.
The $100k grows to over $300,000 in 20 years when you use it to buy investment assets. You will have $58k in purchasing power 20 years if you keep the money in cash (inflation). Finally, you’ll have $4,000 in year 20 if you buy a $100k car.
Income vs. Net Worth
Here is the deal. You can have a huge income and negative net worth. Or you can have a mediocre income with a massive and growing net worth.
It’s not about what you earn. It’s about the assets you buy and hold with what you earn. A high income is great, but it’s not enough.
Growth of investment assets will eventually exceed your income. At that point your money is working harder than you can.
Find Your Net Worth: Net Worth Calculator
You can find your net worth via this free Google Sheets net worth calculator. It will breakout your assets into the 3 asset types I covered above.
You can edit it in Google sheets if you have a google account, or you can download an excel version.
The investment assets portion of the tracker is geared towards Canadians. Americans can easily change these to reflect the US tax sheltered accounts.
A Stoic Approach to Net Wroth
The stoics focus their energy on what they can control.
A portion of your net worth is beyond your control. This is especially true if a large fraction of your net worth is in investment assets.
Factors outside of your control that affect net worth include:
- Stock market returns.
- Real-estate appreciation.
- Interest rates.
The stoics would urge you not to hyper-focus on the net worth value. Instead, focus on the processes that are within your control to grow your net worth.
So, what is within your control? Here are a few factors that are in your control:
- Your savings rate.
- The type of assets you buy with your savings.
- Your expenses.
- Your human capital (income).
- Your habits and behaviors permit consistent savings and investing.
“My post on The Two Most Important Factors to Grow Wealth looks at the two most important net worth building systems that are within your control.
- Net worth is a measure of financial health. It can tell you where you are and can give you something a financial goal to aim at.
- Net worth (monetary wealth) provides time freedom and can expand your circle of influence.
- The three asset types are use assets, investment assets, and monetary assets.
- The decisions on the assets to buy will determine if your net worth grows, plateaus or declines.
- Your net worth value depends on some factors that are outside of your control. Ignore these factors.
2 thoughts on “Your Net Worth: Why It’s Important”
This is very well laid out to understand. Looks like investment are the way to increase your net worth. Thank you
Net worth is an important concept to understand. It is easy to place too much emphasis on income, and it’s easy to get hyper-focused on the numbers.
Comments are closed.