The Net Worth Mentality

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

bogleheadsThe 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.

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  1. Frugal Dad says:

    “It’s not how much you make, it’s how much you keep.” That’s why there are so many people earning six figures and broke. They are not funneling that fabulous income into savings and investments, rather spending it on expensive homes, cars and frivolous spending. I was in that category, too (not the six-figure income part), until I realized that blowing all my earnings was getting me no closer to doing something that I loved, free from the rat race.

  2. Saving Freak says:

    This is one of the main reasons to push the ideals of frugality. Being frugal does not make you boring it makes you wealthy. Frugal people still go on trips and own nice homes. They just pay for it all in cash and pay off their homes early. By not spending on frivolous things we are able to build up net worth and do what we want instead of just working for an income level.

  3. Peter says:

    I find Net Worth to be a good thing to track my financial situation in the long term, but there are so many bumps in it it is hard to see any small changes on the short term. I try to do it at the same time each month so that rent is already taken out, but with twice a year car insurance payments, occasional trips, and other irregular items (most of which we have already set aside money for earlier to take out the bite when they come due), it is hard to see a difference if I spend an extra $10 bucks on something that isn’t necessary. In the long term that amount would grow, but you won’t necessarily notice it in your net worth.

  4. Luke F says:

    Really good article. I like the goals portion of it. Instead of just trying to build up as much as you possibly could, putting goals in place can, as you said, help you pay down that $100,000 in debt. Again, very interesting piece.

  5. Andy says:

    I like the networth tracking for goals and such. I know you are also a fan of Your Money or Your Life, and I also like their idea of tracking your expenses vs. income from passive investments. Over time I think that would be a very motivating tool to see your retirement inching closer. In addition, you can set spending goals and watch your expenses decrease.

  6. Enoch Ko says:

    Hi Trent,
    Great follow-up on your budgeting post. Incidentally, I wrote up a post on calculating your expected net worth this week. I compare my current net worth to past years to determine my progress, then compare against my expected net worth to see if I’m on track to retire with enough to last through my funeral.

    Unlike you, however, I use net worth only as part of a collection of indicators of financial performance.

  7. Dave says:

    Trent,

    The phrase “8% annual return compounded monthly” doesn’t make mathematical sense. It’s either an 8% yield compounded monthly (coming to 8.3% return) , or it’s 7.7% yield compounded monthly, resulting in an 8% return. Jussayin’.

    Dave

  8. Good article. I’m surprised you didn’t even mention NetworthIQ. I use that to track my networth and like it a lot.

    I don’t find net worth tracking for short term goals that helpful. Once you get a significant portion of your net worth invested, your NW is driven by the market. I suppose for debt reducation it is more useful, or cash asset tracking.

  9. oldmiter says:

    I think this post sums up the main point the Dave Ramsey fanatics are missing. I have large debt that is not going to go away soon (mostly student loan and mortgage), but because I’m saving around 2K a month for retirement and emergency needs, my net worth is increasing rapidly and my debt is only slowly shrinking. The craziest Ramsey-ites ascribe to a camp that shuns debt at the expense of betterment. I remember a post from this site (or another popular PF blog) about a woman who was beside herself over her husband’s impending Vet school debt. This education was his dream and expensive, but all she could think about was the short-term debt they were incurring: not about how happy her husband would be doing his dream, or about how they would easily be able to pay off the debt when he graduated. Dashing ones dreams over a fear of debt is a life lived full of regret. I’m glad I went into debt to go to an awesome albeit pricey school, because it helped me to get a job I love that pays nicely. I’m glad I went into debt to buy a cute condo in a great location I love and can afford. I can be glad having these huge debts because my net worth is going up every month.

  10. Diane says:

    A great tool for tracking your net worth is http://networthiq.com.
    This site also allows you to compare your net worth against others in the same income, industry, or location as yourself. For some people, competition is the best motivator!

  11. Emily says:

    A great article Trent, though I agree with StackingPennies that Net Worth is a questionable yardstick for short-term goals. I got too antsy seeing a bad stock market day wipe out a week’s wages. I would tend to forget that the whole point is to buy low and sell high, and every market dip is just another opportunity to buy low.

    I still think that Net Worth is the ultimate measure of long-term financial health, but for the short-term I like to balance it with Monthly Savings as a Percentage of Net Income (which also shouldn’t be used alone because it ignores the invisible “loss” of having low income).

  12. spits says:

    Great Post! I’ve been using Quicken for a few months now and the Net Worth dashboard i find to be the best tool for me to track my growth each month. Reading posts like this reassures me that i am making the right decisions.

  13. KAD says:

    Sorry to bother you, but isn’t 100,000 divided by 60 actually 1666.67?

    Only reason I noticed was that I wondered how much it would take per month to burn what remains of my mortgage ($80,000) in five years, and came up with the same figure of 1333.34. So you inspired me!

    Cheers,
    KAD

  14. Bill Laboon says:

    First off, I agree with StackingPennies, NetworthIQ is an excellent site for tracking net worth. He’s got a good point though… at some point net worth is no longer a good way to determine how well you’re doing financially. There’s a big difference between having a net worth of, say, $100,000 due solely to home equity but no savings, or having $100,000 in index funds and a house worth exactly what you paid for it.

    It’s definitely better than not doing any tracking at all, though!

  15. Devoloping the “networth” mentality is exactly what helped us as we were paying off our debts. At first I would think “ok, i’m sending this $2000 to the credit cards, it sure would be better to put that in a savings account so that we would have it handy”.

    We had lost focus of the “big picture” and this is exactly what looking at your finances from a net worth prospetive does. As long as you do something positive for you finances your net worth will improve.

    It helped me to see a “gain” even as we were paying off those stupid credit card balances, car notes, and student loans.

  16. stngy1 says:

    Big picture, this makes a lot of sense. For us, there is a real problem using this analysis: we’ve owned our house for 20 years, and its market value -even now- is 5 times the purchase price. We also have some great investments. Neither of these are really touchable though, so despite looking good on paper, we still have major budgeting concerns. As you say, you have to focus on INCREASING your net worth, not the absolute number.
    It is fun to go to Yodlee and see it all spelled out, though.

  17. Nate says:

    I use the net worth calculator every month.

    If you have a negative net worth I think he covers that one TSD somewhere as well, it’s a slightly different calculation. I just finished my first quarter net worth change and it was fun to do and see.

    Exciting stuff.

  18. gr8whyte says:

    Don’t forget interest accrual, e.g., for a present debt of $100,000 at 8% APR compounded monthly, you’ll need $148,985 in 5 years or ~$2,028/month.

  19. Becky says:

    Is there a point when you are saving just to save? Once you have paid off your debts and are meeting your retirement savings how do you find the balance between saving everything and “enjoying your hard earned dollar”? What is the difference between living like a monk and irresponsibly spending wages?

  20. Todd says:

    Would the United States be considered wealthy by this rationale?

  21. getagrip says:

    A concern I’d have is that by tracking your networth so closely every month, you can fall into the mode of focusing on the short term gain while forgetting long term benefits. For example, if you’ve saved $7000 for a vacation, that’s part of last month’s networth. You spend it this month, now your net worth took a $7000 hit. Sure, you can note that, but you’ve definately missed your goal. Now add that the stock market may be down the next month, affecting both retirement and investments, and your house value continues to slump, and now you’ve got a three or four months of negative net worth. Suddenly the thought of switching your investments to more “stable” funds seems much more attractive since the focus on your networth is raising your anxiety level due to it’s decline.

    This can start to affect your overall outlook down the road if you aren’t careful.

    My point is that many of the things you will do to grow as a person and with respect to your long term finances will likely have a negative affect on your networth in the short term. Just don’t get wrapped around the axle about it.

    While this article presents an interesting way of looking at networth, I still feel the best use of networth is checking if you’re better off today than you were a year ago, both in general and in specific categories (e.g. retirement, savings, property values, etc.).

  22. Andy says:

    One problem with the net worth model is that rapidly rising home values or stock values can give people the idea that they have a higher net worth and that they can therefore spend more. I think that part of our national debt and spending problem is a result of this.

    Instead of focusing on net worth, it might be wise to have several sub-goals — decreasing mortgage debt, increasing cash (minus consumer debt), increasing retirement savings. This way, even if the old 401k goes up, there isn’t that temptation to spend cash.

    Or, like me, if your 401k and house value goes down, but my cash is up, I know I’m okay.

  23. Net worth planning is the first step in determining your future financial success. I’ve always it puts the keep on your financial boat. You now know which way you are going and are not drifting aimlessly.

  24. Steward says:

    I am definitely still in the budgeting stage and haven’t moved over to only using net worth as an indicator of our financial health. I budget because our expenses will be changing soon, it helps me really know where our money goes, and the money coming in is still really close to the money we have going out. It sure would stink to stop budgeting and see what little funds we have accumulated dwindle rapidly. I bet that once my income begins to far out pace my expenses than a monthly budget won’t really be that necessary.

  25. Eve says:

    If you have any kind of account at Bank of America, you can set up the free “My Portfolio” to pull in information from all your other online accounts, no matter who the other accounts are with. Then “My Portfolio” will track your net worth automatically, every time you log in. I love it.

  26. getagrip says:

    @ Becky IMHO you should never be saving just to save. You should have a goal for your savings, the more concrete the better. It should be for something that will give you value either now or down the road, be it getting out of debt, a vacation with family, new tools for a hobby you enjoy, local classes to expand your knowledge and possibly help with making you more marketable, or retirement. The point is to enrich your life with better planning and forethought. Not to live like a miser counting coins in a shack.

    Once you’re out of debt, you should also be budgeting for those things you know you’ll need and use in the future. That beater car your driving will likely need to be replaced in a few years, why not get a nicer used vehicle, or even a decent new one if you have the savings and can pay in cash? Perhaps you’ve always wanted to see Europe, save for it and go (hey, the dollar might be stronger in a year or two). Take your mother on a cruise if it’s something both of you have always dreamed of and it’s within your vacation budget.

    The point is to have defined goals and save for them. If you’re swimming in debt, other people are defining the bulk of your financial goals for you because you owe them. Once you’re out of debt, you have more freedom to define your own goals and that is what you really want.

  27. fathersez says:

    Different strokes for different people.

    Some will say that the net amount to be saved per month will be a function of how much we earn and how much we spend. So it would be better to use the earnings and spendings as targets.

    I suppose each of us would have to figure out the best fit for us, and the less the better.

    We use net worth as our metric. But have recently done a spending budget to help us align ourselves better.

    Regards

  28. Joyce Jarrard says:

    Quicken Woes & Dave Ramsey Philosophy

    This article and subsequent discussion are all very interesting, especially the posts bringing up the Dave Ramsey point of view and its hindrances to educational investments. Just remember that Dave Ramsey was badly burned by excessive indebtedness, and lost everything he had – millions! In this over-leveraged economy, his financial conservatism is a “gospel” that needs to be spread. However, if you are young, an investment in career education will pay off in the end, especially if you make eradicating that student loan debt a high priority after college. Dave’s advice to work part time while going through school is also wise, to minimize borrowing. (I’m in my 50′s, so I’m debating whether I can recover the costs of some needed classes & certifications to advance in my career.)

    I too have been tracking our finances in Quicken for the past 3 months. (I had a lax period of 3 years where I ignored everything, because of family, medical, and career crices, to our financial detriment.) I actually transfer our month-end Net Worth figures to an Excel spreadsheet to track our comparative Net Worth. We are on a campaign to get out of debt. Unfortunately, although we’ve made many financial improvements and payed down debt in the past 3 months, our losses in our 401(k)’s have offset our other gains! I don’t even want to know how much our home may have dropped in value. (No real estate is moving around here in NC.)

    I find the Quicken Deluxe budget tool to be frustrating. Am I alone in my frustration? My Quicken budget gives misleading results, because it doesn’t show the principal paid on debt, which must come out of income. (Because of this design flaw, it makes it look as if you have more money to allocate than you really do.) I finally just did an Excel two biweekly “payday” budget and attached it to my checkbook. I know now how much I need to have in the bank at the end of payday #1, to be able to pay all the large bills that hit after payday #2.

    I also find the Quicken Deluxe investments impossible to update accurately. I finally just gave up and I change the numbers on my Excel spreadsheet.

    I’d love to hear from some Quicken experts. Do I need to upgrade to Quicken Premier to overcome this problem with tracking 401(k) balances and stocks? You can e-mail me at Claudette1872@yahoo.com.

  29. gr8whyte says:

    @ Becky (comment #19)

    I sense you’re not asking for tips on how to spend truly discretionary income but are seeking the optimal balance between saving and spending it all. Trouble is, there is no correct answer. It all depends on the individual. You need to figure out for yourself where you’d be most comfortable between the two extremes of save-it-all and spend-it-all. I don’t recommend either. IMO, it’s best to be somewhere in the middle and I lean a little towards the saving side because life is unpredictable; what’s here today can easily vanish by tomorrow.

    Here are some tips you never asked for : Give some of it to charity and you won’t regret it (the orgs involved in feeding the hungry are in difficulty now). Help a family member in need. If you don’t have it now, consider buying long term care insurance (inexpensive when you’re younger). Consider saving a bit more now beyond just “meeting your retirement savings” for an earlier retirement.

    No matter what you do, try to avoid irresponsible spending. Your income represents hours of work in a younger period of your life that you’ll never re-live again (some planners call it your life force that you’ve exchanged for your income). Precious stuff; don’t waste it.

    I think you’d be way happier in the long run if you saved and gave judiciously, and never spent irresponsibly.

  30. Duane says:

    Having tracked the net worth for years, I can say that it is an invaluable tool but I wouldn’t suggest using it monitor month by month progress. As your portfolio grows you will find that your ability to impact its value in any given month is limited because the tide of the general market makes a bigger wave than your frugality.

    This is actually all the more reason to continue to track it, but for different reasons. Early in one’s investing career the Net Worth calculation keeps you honest on short intervals. Later on it helps you monitor investment performance and you can safely assume the habits of frugality have become natural.

  31. James says:

    Another great posting from the simple dollar.

    Many people, including smart PhDs and policymakers seem to think that incomes are the same thing as wealth.

    This is really a shame because overall wealth really is best defined via net worth. Also, I don’t necessarily agree with Duanes comment (above), calculating your net worth can help you to meet monthly goals or to help you update any long term picture you have of your wealth.

    Best,

    James

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