Last week I published our net worth. But the concept of net worth isn’t as useful as you think, for the following three reasons:
- The wealthier you are, the less accurate net worth becomes.
- Net worth alone can’t buy financial independence.
- High net worth doesn’t mean you’re trustworthy.
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Last week I broke down the different components of our net worth, which as of September 2020 was $3.047 million. At the end of the article, I teased that I don’t actually love the concept of “net worth.” Today I’m going to explain myself.
The purpose of your net worth
Let’s put my situation aside for a minute and examine the purpose of “net worth.” In general, people use their net worth to know how rich they are compared to their peers. In the world of personal finance, it’s just a bit more nuanced.
Here are a few big reasons why you or society might want to know your net worth:
- To know your wealth
- To know how close you are to financial freedom
- To judge your trust worthiness
Unfortunately, I don’t think “net worth” is that useful for any of these purposes. Here’s why:
Net worth and your wealth
Many people use net worth to determine how wealthy they are. In fact, it’s the most common yardstick to compare the wealthiest people on earth.
The problem is that it becomes increasingly difficult to accurately calculate your net worth as you gain wealth.
For example, let’s say you’re just starting your financial journey and have one credit card, one checking account, and a car loan. Your net worth is a simple calculation. Just take your checking account balance and subtract your credit card debt and the car loan.
But let’s say you’re Jeff Bezos, the wealthiest man on earth (in late 2020). Now, the vast majority of your wealth is concentrated in a business. The worth of that business changes daily. The business itself has lots of assets and liabilities.
You also own a lot of real estate. The worth of your property is subjective, and is only worth what someone is willing to pay for it. You’ve also got a lot of other securities and stocks, and again, the value of this all can change in a heartbeat.
In my case, I shared last week that the Zestimate of our primary home is $2.8 million. But I think Zillow is wrong. When I look at their data, it’s pulling in comps from a much ritzier neighborhood a couple of miles north. I think the actual value of our home, based on local historical sales, is about $2.25 million. So the net worth I shared last week is probably off by at least a half million dollars!
Do you feel deceived? Dismayed? You’re not alone. A lot of people get really upset when the reality of someone’s wealth doesn’t fit with the perception of their net worth.
So that’s problem #1 with net worth: the wealthier you are, the less accurate net worth becomes.
Net worth and your financial freedom
It’s also problematic to use your net worth as a mile marker on your journey to financial independence.
This is a common mistake in the FIRE community, where there’s a lot of focus on gathering assets to retire from a typical 9-5 job.
Based on data from the Trinity Study, you’re financially free when your stock portfolio is worth 25 times your annual expenditures. The data suggests that in almost any time period, it’s safe to withdraw 4% a year from a well diversified stock portfolio and not run out of money after 30 years.
Check out my original calculations that showed a target of $10.8 million needed to reach financial independence!
But while accumulating a nest egg, it’s often really tempting to lump in the value of assets like your primary home into your calculations. Even the very user friendly retirement calculator on the Playing With Fire website uses the term “net worth” to describe assets, instead of the more specific term “securities” or “stocks.” This is a very dangerous confusion.
If I quit my job based on the Zestimate of $2.8 million for our primary home, I’d be in for a world of hurt when I went to cash out. After adjusting the sales price to the $2.25 million supported by the market and subtracting out broker fees, we’d walk away with a half million dollars less than expected.
But even index funds have issues for supporting your life of financial independence. As I’ve argued in the past, you need to convert stocks to cash to actually use it to pay for things like avocado toast and oat milk lattes. Unless you’re going to live on your Roth IRA alone, the conversion of stocks to cash inevitably incurs a tax hit.
For example, we recently converted $200,000 of stocks from our taxable accounts to divert to real estate. Because of capital gains, we’ll likely see about a $20,000 tax bill from this transaction.
Read more about my real estate investing adventures.
So to sum it up, net worth isn’t a great number to use to track your progress towards financial freedom. You’re better off using stocks (or rental income). Even then, you have to make sure to account for the costs associated with liquidating the stocks to cash.
So that’s problem #2 with net worth: Net worth alone can’t buy financial independence
Net worth and trust
Last but not least is the connection between net worth and trust. This was the reason I tabulated our net worth last month — a bank wanted to know this to see if we’re good candidates for a loan. Could they trust us with yet another mortgage loan?
More generally, you might be tempted to view someone as trustworthy if they have a high net worth. She’s worth a lot of money, so I can trust her, you might think.
But is net worth a useful number for this purpose either?
I don’t think so. Just because you have a high net worth doesn’t mean you have morals or ethics. There are plenty of unscrupulous characters that have a high net worth due to good luck, family money, or plain old lying.
Luckily for our society, most banks use additional factors such as debt to income ratio to judge creditworthiness. This system broke down leading up to the 2008 financial crisis, but it’s improved a lot since then.
So I’d caution you away from using net worth as a surrogate for trustworthiness. Most people who boast publicly about their net worth are likely not worthy of much trust at all. (I see the irony here, of course.)
That’s problem #3 with net worth: High net worth doesn’t mean you’re trustworthy.
We’ve established now that your net worth isn’t as useful as you think it is. As you grow wealthier, net worth becomes less and less accurate. It’s probably not the best number to assess your proximity to financial independence. And it certainly shouldn’t be confused as a proxy for someone’s trustworthiness.
So what’s it good for?
As long as you recognize its limitations, it can be a rough measure of financial progress from year to year. If your net worth is growing, it’s generally a good thing. That’s it!
Do you agree with all this, or am I not giving net worth the respect it deserves? Comment below and please subscribe for more posts!