Earlier today, I was thumbing through the excellent book The Millionaire Next Door, when I came across an interesting discussion about a person’s net worth. The authors, William Stanley and Thomas Danko, offer up a rule of thumb for a person’s net worth:
Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.
(A quick refresher: a person’s net worth is the total sum of their assets – their home, their car, their bank accounts – minus their debts.)
So, let’s say you’re thirty years old and you make $35,000 per year. According to this formula, your net worth should be $105,000.
That seems on the surface like it might be a good calculation, but it is loaded with flaws that simply don’t add up.
Take me at age 23. I made $43,000 that year pre-tax. It was my first year out of college, so I was saddled with student loan debts and I hadn’t been earning very much up to that point. According to their formula, my net worth should have been just a hair shy of $100,000. Unsurprisingly, it was negative.
It also creates some unrealistic numbers for people later in life. Let’s say someone is 65 and has been working for minimum wage all of their life, causing them to live paycheck to paycheck all the way through. It’s been a struggle for them, but they’ve been banking on Social Security for retirement and they’ve managed to survive. This year, the person makes $20,000. Stanley and Danko believe that this person’s net worth should be $130,000. That’s just not realistic.
What are some good solutions for this?
First, I’d subtract a minimum living wage out of the equation. If you’re only making minimum wage, it’s not realistic to expect you to start building up a big net worth. All of your money is going to keep your head above water. So, I’d subtract $20,000 a year (at least) off of the salary and probably an additional $5,000 per additional dependent. So, for a family of five, I’d subtract $40,000 off of that salary number.
Second, I’d use an average of the person’s last ten years of income. So, if you look at me at age 23, my average earnings for the previous three or four years was about $8,000, and for the years before that it was essentially $0. This would give me an average of $6,700.
This works very well with the “subtract out the minimum wage” rule for people freshly out of college. My net worth at age 23 would have been -$30,590, which actually wasn’t too far off. With each subsequent year, that net worth starts inching upwards, which is realistic because I would have been paying off that debt.
There’s a third problem, though, once you start making those changes. If you’re looking at someone making a good wage over a long period of time, these revisions undercut how much they should have built up for their net worth. The original rule of thumb works well for people with a healthy income over a consistent period of time.
The solution that I see is to reduce the number that you divide your average income by. This doesn’t have much impact on people who don’t stray too terribly far from the minimum wage as an average income, but it has a pretty big impact on people who consistently earn a healthy wage. I tried fitting various numbers to my own historical financial progress and found that reducing the number from ten to eight seemed to have a very reasonable impact.
So, what does this turn the “rule of thumb” into?
“Take the average of your last ten years of pretax income. Subtract a living wage from that average, meaning $15,000 plus $5,000 more for each dependent (including you) on your taxes. Multiply that by your age, then divide by eight. This will give you a good estimate of what your net worth should be.”
This, of course, isn’t a perfect calculation. No such “rule of thumb” ever is. However, I think it creates a more realistic view of people’s lives. It matches up much more realistically for the situation I found myself in immediately after college, as well as the situation I find myself in now. It also matches up well with the situation my parents are in.