After posting my budgeting 101 article yesterday, I almost immediately got a response from a reader who had a very good follow-up question:
You talk all the time about setting goals and measuring progress. Without a budget, how do you set personal finance goals for yourself and measure progress?
My wife and I use only one metric to measure our financial progress – net worth. No other single metric says so much about our financial state.
Defining Net Worth
To put it as simply as possible, net worth is the value of your assets minus the value of your debts. In other words, if you sold everything you owned, emptied out every account, and paid every debt, how much cash would you have on hand (or, possibly, how much debt would you still have)?
Over time, a household with their financial hat on straight will see an increase in their net worth. They’ll spend less than they earn and invest the difference in some fashion. On the other hand, if there are financial difficulties, a family’s net worth might decrease over time, meaning their debt is increasing at a rate faster than their earnings – a very bad sign.
If you’re interested in trying it out yourself, here’s how to build your own net worth calculator.
Using Net Worth to Track Positive Financial Progress
Using your net worth to keep track of your financial progress is easy. Just calculate your net worth each and every month and track it over time. You might not necessarily see a jump every single month, but over the long haul, if the general trend is upwards, you’re in fine shape.
This long-term approach is much better, actually, than a monthly budget in terms of seeing the benefits of lifestyle changes and smart financial moves over the long haul – it constantly forces you to see the big picture, not just the picture of that specific month. You might not think a change that saves you $10 a month is a big deal from just the view of a monthly budget, but that $10 saved every month over ten years creates quite a different picture – used properly with an 8% annual return compounded monthly, that $10 a month becomes $1,802.12.
Because of that, things like buying in bulk and investing in quality stuff with a long lifetime show up as beneficial on a net worth progress chart, but don’t look nearly as good on a monthly budget sheet.
Using Net Worth to Set Short-Term Goals
My net worth calculator is a constant supplier of short term goals. Each month, I look at the sum total of assets and of debts and use that data to set small goals for the coming month – an asset increase of 1%, for example, or a debt reduction of 1%. These short term goals force me to keep my eye on the ball – talking myself out of buying VMWare Fusion, for a recent example – and keep myself constantly motivated.
These little goals are achievable, but by themselves they don’t seem like a whole lot. But look at it this way – if I target a debt reduction of 1% each and every month for a year, 11.3% of my total debt goes away. If I then keep pushing myself – moving that goal up to a 1.25% reduction every month, for instance, and then to a 1.5% reduction and then to a 2% reduction – I can push all of that debt out the door in just a few years.
Not only that, achieving those little goals over and over again enable big goals.
Using Net Worth to Define Long-Term Goals
Let’s say I want to achieve debt freedom in five years without reducing my current assets – that’s a big, audacious goal for most people. If my total debt is $100,000, that means that my true goal is to increase my net worth by $100,000 in five years.
How can I do that? $100,000 divided by 60 is $1,333 – that’s how much my net worth has to increase on average each month over the next sixty to achieve debt freedom.
I then set that as my small goal each month – my net worth needs to go up $1,333 that month. How can I do that? I can pay down extra debt. I can invest smartly. I can buy in bulk, effectively investing now for the future. I can work hard for extra income.
All of these little goals spring from a big goal, and that big goal is all about the net worth.
The Net Worth Mentality
The idea of net worth as a primary method of figuring financial success is a concept explained very well in the wonderful book The Bogleheads’ Guide to Investing by Taylor Larimore, Mel Lindauer, and Michael LeBoeuf – I reviewed this one a while back and loved it.
Here’s what they had to say about the net worth mentality on page 7 of the paperback edition of the book:
From the time we are old enough to understand, society conditions us to confuse income with wealth. We believe that doctors, CEOs, professional athletes, and movie actors are rich because they earn high incomes. We judge the economic success of our friends, relatives, and colleagues at work by how much money they earn. Six- and seven-figure salaries are regarded as status symbols of wealth. Although there is a definite relationship between the income and wealth, they are very separate and distinct economic measures.
Income is how much money you earn in a given period of time. If you earn a million in a year and spend it all, you ad nothing to your wealth. You’re just living lavishly. Those who focus only on net income as a measure of economic success are ignoring the most important measuring stick of financial independence. It’s not how much you make, it’s how much you keep.
It’s not how much you make, it’s how much you keep. That’s a very strong assertion, and one that a lot of big spenders would argue vehemently with. But it’s true. The money you keep is the money that will allow you to be truly financially free. The one true path to a future where you can do whatever you want is to have a high net worth – without it, you’re guaranteeing yourself a lifetime of work and limited choices. With it, though, you can walk away from your old career anytime you want and chase your dreams – that’s what I did.