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When Net Worth Calculation Fails You
Megan writes in with a great question:
As per your earlier suggestions, I have been using net worth to track my financial improvement over the last five years. The spreadsheet shows a nice monthly upward trend almost every month. But this month I noticed an interesting problem. My net worth went down even though I was spending a lot less than I earn. If you’ve looked at the stock market you know why. The S&P 500 has went down about 200 points in the last month, causing my retirement to lose about 6% of its value. Because my retirement savings is now such a large part of my net worth, a stock market drop means my net worth drops even though I am doing the right thing. Do you have any suggestions for how to correct for this? That red number on my spreadsheet looks bad even though I know it actually looks pretty good. This happened in December too.
This exact same thing has happened to me several times over the years. Although I’m saving money and contributing to retirement, my net worth for the month goes down simply because I have quite a lot saved up compared to my monthly contributions.
Let’s spell this out with an example. Let’s say I contribute $1,000 a month to my retirement account. After six months, I have $6,000 in there. The stock market goes down 10%, leaving me with only $5,400, but then my $1,000 monthly contribution comes in, I’m at $6,400, and my net worth is still going up. That’s because I just started investing and the amount I’m investing each month is still a fairly large portion of my overall investment.
Now, let’s move five years down the road. My investment is now worth $80,000, and I’m still contributing $1,000 a month. Over the next month, the stock market drops by 10%, leaving me with $72,000. Even when my $1,000 contribution for the month is added, my balance is still $73,000, meaning my net worth went down by about 8%, even though I was doing the right thing.
Here’s the important thing to remember: your net worth is a very useful number in many ways, but it’s not the only number that matters. It’s a single number that just gives you a snapshot of your overall financial state, and by comparing it to the past, you can see how your overall state compares to various points in your past.
When you do month-by-month comparisons and have a large investment in something volatile like the stock market, there are going to be months where the value of your investment drops significantly and no matter what good moves you made in your life, your net worth is going to drop compared to one month prior. There’s nothing wrong with this, but, as Megan notes, it can be unsettling when you’re working hard to keep the trend moving upwards.
So, are there better metrics that take this into account? Here are four other things to measure that might provide more value.
First, if you have enough data, consider looking at year-by-year comparisons of net worth rather than month-by-month. For instance, you would compare your net worth for June to your net worth for June a year ago. If you’re being smart with your finances and don’t have many multiples of your annual income in investments, this should virtually always be a positive number outside of exceptional periods like late 2008. Even a 10% drop in the stock market over the course of a month will likely be overshadowed by the savings contributions and growth over the course of a full year.
It’s easiest to see this as an example. Let’s say you calculate your net worth each month for a full year and it looks like this:
January, Year 1 – $100,000
February, Year 1 – $105,000
March, Year 1 – $110,000
April, Year 1 – $115,000
May, Year 1 – $120,000
June, Year 1 – $125,000
July, Year 1 – $130,000
August, Year 1 – $135,000
September, Year 1 – $140,000
October, Year 1 – $145,000
November, Year 1 – $150,000
December, Year 1 – $155,000
January, Year 2 – $110,000
Wow, that December Year 1 to January Year 2 drop is significant. A -$45,000 change in a month looks awful in your net worth calculations. On the other hand, if you’re using year-over-year comparisons instead of month-over-month numbers, it’s actually a +$10,000 change.
Second, if you have enough data, consider using a moving average of your net worth rather than a month-by-month comparison. A moving average means that, rather than worrying about your net worth right at this moment, you’re more concerned about your average net worth over the last year. You just add up your monthly net worth calculation for each month over the last year and divide by twelve. Then, next month, you do the same thing, except it’ll include that month’s data and the data from a year ago will drop out.
For example, with the data above, the twelve month moving average in December is $127,500 – just add up all of those numbers and divide by twelve.
In January Year 2, even though that month was clearly horrendous, the twelve month moving average still goes up from $127,500 to $128,333.
Using a twelve month moving average allows you to see the overall trend in your efforts with a lot of the volatility in a single month muted. It means that a really bad month won’t cause a big decline, but it also means that an exceptional month won’t cause a big jump.
Third, consider focusing on your monthly savings rate rather than your monthly net worth. This allows you to focus on your own individual efforts to save rather than the volatility of your investments.
To calculate your savings rate, simply add up the amount of money you saved this month for long term goals – usually your retirement savings, but perhaps savings for other goals – and then divide that amount by your total income before taxes for the month. So, let’s say you saved $1,000 this month and earned $8,000, your savings rate is 0.125, or 12.5%.
Ideally, you want this number to stay steady over time or, even better, creep upwards a little bit. For example, you might see your savings rate staying steady over time and you might choose to bump up your contributions by 1% or so, which will definitely help your savings rate.
This number might be kind of boring – after all, it only changes when either your income changes or the amount of money you save in a given month changes (and if everything’s automatic, this probably won’t happen often) – but it shows you clearly that everything’s moving along as planned.
Finally, consider focusing on your discretionary spending rather than your monthly net worth. Simply add up all of your spending that wasn’t used for basic needs. Include things like gourmet foods, entertainment services, and so on. You may want to use discretionary spending as a percentage of your income (if you’re okay with some lifestyle inflation if your income goes up) or as a raw dollar number (if you want to keep your lifestyle the same).
This is a really good number to use with a moving average, as described above, so you even out changes in your spending over the course of a year.
It’s also the best way I know of to see if lifestyle creep is happening in your life, which can be an early sign of financial troubles to come. If your discretionary spending is consistently going up, particularly at a pace that’s greater than increases in your income, you’re probably slowly headed toward financial difficulties and hard choices. It’s much easier to head this off when it is small and hasn’t created a ton of bad habits and a big financial hole yet.
So, which one do I use? I actually use all of them. Once you have a system for calculating a particular number, it’s not hard at all to start making comparisons. Once you’re calculating your net worth every month, it’s easy to do a month-over-month comparison once you have two months of calculations – just subtract last month from this month. Switching to year-over-year is simple once you have a year of data – just subtract last year from this year. Even a moving average isn’t hard at all – just add up the last twelve numbers and divide by twelve. All of this can be automated with a spreadsheet like Google Sheets – once things are set up, it’s mostly just a matter of typing in your numbers for the month and everything is added up for you. If you want a basic tutorial on how to set up a net worth calculator, I wrote one several years ago that works well for Google Sheets.