One nugget of personal finance information that I’ve seen repeated over and over is the notion that if you have a year’s salary saved for retirement at age 35, you’re on pace to retire very nicely at age 65. It actually turns out that the statement is more or less true, if you assume, of course, that you continue saving at that same rate for the next thirty years, your career doesn’t take any major twists or turns, and the American economy stays relatively strong.
As you read through that list of assumptions, you’re probably thinking the same thing I’m thinking: that’s a pretty tall order. How many people go from age 35 to 65 today without some sort of significant career alteration? Even if you manage to do that, can you assume you’ll always be able to save at the same rate? And let’s not even talk about the health of the economy over the next thirty years with the coming retirement wave of the baby boomer generation. To be honest, it’s anyone’s guess.
Here’s another example, one I like to pull out one of my favorite little “rules” from an otherwise great personal finance book, The Millionaire Next Door. In this book, the authors propose a very simple formula for figuring out if you’re being smart in terms of your net worth. You should be able to take your annual pre-tax household income, multiply it by your age, and then divide by ten. If your net worth is more than that, you’re doing well; if it’s less than that, then you’re not doing your job in terms of accumulating wealth.
The problem with this formula is that it doesn’t do a very good job of looking at the normal life changes that people go through as they grow older. It might be fine for someone approaching retirement, but think for a moment about someone who just graduated from college and just got their first real job. Let’s assume this person is 22 years old and just got a $40,000 a year job. That means, according to this formula, they should have a net worth of $88,000. The problem, of course, is that the typical college graduate has very few assets and also has a bunch of student loans. Most likely, that graduate has a negative net worth, not a positive one.
According to the book’s authors, this recent graduate, who might have a great degree, awesome career potential, and a relatively small batch of loans, is actually a complete failure financially. In reality, that person might be in position to do spectacularly well during their professional life while making smart financial moves and end up blowing that formula out of the water.
At best, that calculation could serve as a motivator for someone who’s not saving very much. When I used it to evaluate our finances back in 2006 or so, we were pretty clearly not measuring up. However, I don’t feel that we’re “successful” today just because we crossed that threshold in the last few years.
Another simple “rule” that I often see is that you shouldn’t buy a house that costs more than two years or three years of your gross annual income (I’ve seen both variations). For example, if you make $100,000 per year, you shouldn’t buy a house that costs more than $200,000 or $300,000 (depending on the rule).
What’s wrong with this rule? It doesn’t take into account how much of a down payment you have. It also doesn’t take into account income volatility either – some people have jobs that earn different amounts from year to year.
Yet another “rule” I often see is the 10% rule, which suggests that you should be putting 10% of your income away for retirement each year. It’s a useful suggestion for a number to put down if you literally don’t know anything at all when signing up for your 401(k) plan, but it is far from anything that you should rely on for retirement. Why not? That 10% number assumes that the stock market will keep going up steadily and it makes big assumptions about how many years you are from retirement (hint: a lot of years) and how much money you’re going to want in retirement (hint: most of, if not all, of your current salary), among other things.
Here’s the real problem: those little convenient financial “rules” that tell you that you’re in a good spot (or not) are often entirely dependent on so many factors going perfectly that they’re practically useless. They almost always rely on big assumptions about you, big assumptions about your future, and big assumptions about the future health of the economy. Those assumptions are so enormous that the information you get from such formulas is practically worthless.
Given that, how can you tell if you’re on track for your financial goals?
In my eyes, the only thing that matters in terms of evaluating your own financial health is your own recent past. In other words, your focus should be on comparing your current financial state to your state a month ago or a quarter ago or a year ago. Are you in better shape now than you were then?
Why is this so important? It eliminates all of the assumptions of all of these other financial rules and replaces them with the reality of your own life. You don’t have to wonder whether the author of this financial rule knows anything about the reality of your life or your specific challenges. When you use your own recent past as the point of comparison, that’s all included.
If you want a single number for evaluating your overall financial health, the number that matters the most in terms of evaluating your personal finance state is your net worth, particularly your net worth over time. A person’s net worth is a simple snapshot of their financial state at any given moment. It’s simply the total of all of their assets – their savings, the value of their home and cars, any other valuable things they own – minus all of their debts. Your net worth over time is how much your net worth has changed in the last month or the last quarter or the last year or the last five years.
For example, if your net worth is increasing each year, you’re heading in the right direction no matter what your specific financial goal is. The more your net worth is increasing, in fact, the better. It means that your assets are growing at a faster rate than your debts. Ideally, of course, your debts are shrinking and your assets are increasing over the course of a given year, but even if things aren’t that perfect (say, in a year where you take out a home mortgage), you can still improve your net worth over the course of that year.
You can also use slices of your net worth to check on specific goals you might have. For example, if your goal is to achieve debt freedom, then your focus is on making sure that your debt total (which is a big part of your net worth) goes down each year. If your goal is to build a healthy retirement savings, your focus should be on making sure that your total retirement savings is going up each year.
What about retirement? Save as much as possible. When you have enough in your retirement account that you can live off of 4% of the balance, you can retire or cut strongly back on your retirement contributions. (Why 4%? Even if there are no returns on your retirement account, you’ll be able to live off of that money for 25 years – if you put it into something safe, you’ll be able to live for many, many years.) Simple rules like “save 10% of your income” just hand you a number that may or may not really mean anything. The best practice is to start saving a lot right now (like 20% or 25%), cut back from there if you discover you need to but still keep it high, and then not worry at all about retirement and probably enjoy it early. The thing is, if you start contributing a lot as soon as you start working, you’re not even going to notice it. Your life will adjust to living off of whatever is left over.
What kind of time frame should you be looking at? It really depends on what your goals are. In general, I find that smaller timeframes – on the order of a month – are good for evaluating things like changes in debt and other things that rely very heavily on good day-to-day behavior. When you’re evaluating things that rely somewhat on the success of investments, longer time periods work better because your personal contributions can help overcome small investment losses. I find that evaluating one’s net worth is perhaps best done on a year-over-year basis. I also recommend focusing on contributions more than the account balance when evaluating your savings and efforts for retirement and other savings-related goals.
In the end, the solution is simple: trust in yourself, not in “rules” that have nothing to do with your life. Rely on your net worth to tell you if you’re making good progress and strive to make your net worth grow as rapidly as you can. Put away a lot for retirement – start really big and then only cut back if you need to and you’ll find that it’s not really very hard at all. Don’t worry about “magic numbers” or “magic formulas” that people try to sell you on because those rules are designed without considering anything about your life.
Build your net worth. Save plenty for retirement. Don’t worry about magic formulas and rules. You’ll be fine.