What Should My Net Worth Be?

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.

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  1. Becky says:

    Interesting. I find that using multiple rules of thumb for questions like this is pretty useful, because the range of answers for my situation tells me more than how I match up against one specific number.

  2. moom says:

    This depends on what the purpose of the calculation is. You seem to be saying it should be a measure of what someone could reasonably have saved whereas the original ones seems to be more one of what one needs to save to retire. The main flaw with the original one to my mind is it should be based on annual spending rather than income.

  3. moom says:

    PS – the original calculations says we should have $1.1 million and we only have about half that.

  4. krantcents says:

    There is no comfort knowing I exceed the target net worth! I am still contributing and trying to make it grow despite the volatility of the market. My retirement will consist of a pension, Social Security and my retirement savings.

  5. jackie.n says:

    i submitted a comment in your post “a mindful life”–10 hours now in moderation! either my name is flagged or you have serious issues with your website trent. i suggest you fix them.

  6. Doug says:

    Trent, although I don’t have the book in front of me, I believe that calculation was to be used as a target for the hyper-savers. That is, if you want to be a hyper-saver, you should compare yourself based on this calculation.

    Also, I think they acknowledge that the extreme ends of the spectrum don’t hold up to this rule of thumb. Recent college graduates, extremely low-paid people, etc.

  7. deRuiter says:

    One thing the (handy) net worth information doesn’t cover is how well a person handles money in general. If a thrifty person and a profligate person end up with the same social security payment, and the same net worth, the thrifty person will generally live more a secure and comfortable life in retirement than the spendthrift because he / she will make better use of what they have, not waste money. I mean “comfortable” in the sense that the money will not run out as easily as for the person who spends carelessly. The ability to grow some of your own food in a small garden, to shop estate sales and yard sales for fine quality barely used or still NWT clothing, buying furniture at estate sales, recycling, cooking good meals at home, do some of your own repairs, mow your lawn yourself, all contribute to a more prosperous retirement, and make retirement more agreeable.

  8. I saw that formula in the book and realized it’s a dumb calculation. It assumes you’ve been making the same amount of money you’re making today since you started working, and that your income won’t change for the worse later in life. So my networth is supposed to be $250k at age 28… maybe I could have done that if I was extremely frugal, but I’m at $150k and think that was a pretty big accomplishment. And that was without any student loan debt.

  9. Telephus44 says:

    I’ve been around long enough to see/read several people offer suggestions on how to tweak the formula to make it more “fair.” I agree that it’s not realistic for many situations, most notably recent college grads and retirees.

    The problem I find when you start tweaking the formula is that somehow I feel people start trying to justify why their net worth isn’t that high. Oh, I’m too young. I only make minimum wage. I have too many student loans. Etc.

    I am at just about 2/3rd where I’m supposed to be according to the original formula, but I’m 3 times higher than Trent’s formula. I like to use the original formula as a goal to strive for – guess what, not everyone’s going to get there, and not everyone’s going to be a millionaire. I find it motivating because one of my personal goals in life is to be a millionaire. If your goal is simply to pay off your debts, or quit your job, or travel full time, then it’s not particularly useful to worry about where some random formula thinks you “should” be. You should have your own goals to compare yourself to.

  10. S01 says:

    Any additions to the rule of thumb if you have a spouse or partner? You can’t both count your gross assets as for each of you, but splitting them in half seems a little harsh, as when you retire it tends to be slightly cheaper to live as a couple than as a single.

    Assuming you don’t end up divorced at some point….

  11. Tom says:

    That calculation is Expected Net Worth, not the hypersaver equation (multiply x 2 to be a Prodigious Accumulator of Wealth). The most common complaint of that formula, and I’m not sure if Stanley ever addressed this) is that its never going to work for someone who has just started earning money. I doubt that it was really intended for a 25 year old who probably doesn’t have property, a succesful business, or significant retirement assets and he specifically ignores inheritance for the calculation.

  12. Steve says:

    The calculation is fundamentally flawed because it is too linear and simplistic. It should both be exponential (as your assets accumulate, the interest becomes bigger, while your contributions go up slowly with increased income) and piecewise (for those who go to college, who start with negative net worth, and those who don’t, who start with zero and go up from there).

    I think that your “minimum living wage” change is a red herring, because everyone needs some savings, no matter how poor they are. Zero (or negative) savings just puts you further and further behind the 8 ball.

  13. Danielle says:

    We’re just slightly above trent’s calculation…and we consider ourselves pretty heavy savers, although I can’t see how my family of 5 could live on 25k a year after taxes. Our mortgage alone is $15k a year!

  14. getagrip says:

    The millionaire next door formula is a good ideal to shoot for, but IMHO it’s more for being in mid career in your 40’s and onward where it makes more sense. That said there should be one metric for your net worth. Are you generally better off this year than last year? If not, is because of something you’ve done wrong, or did the market tank, you just have a bad year with illness, etc. If so, was the increase actually due to your actions, are you making things better or taking positive steps. Can you make positive adjustments or are you kind of going overboard and not enjoying things.

    To me, while rules of thumb may be okay to give you some goals to shoot for, for me the bigger value is how are you doing from year to year and are your decisions paying off so that in general, though you may have some dips and bumps, your net worth is rising over time.

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