"Net worth" is a phrase often thrown around as the yardstick of a person's financial success.
In recent years, this measure of wealth has been cited frequently in connection with celebrities of all stripes and recent tax proposals. But is net worth really the ultimate gauge of financial well-being?
Not in all situations. In fact, in some cases, net worth can be so misleading as to leave people with a false sense of security.
5 reasons net worth is overrated
This discussion is not so much about how you should judge the financial success of the rich and famous as it is about how to evaluate your own financial security. To be sure, it is desirable to grow your net worth, but it may not be the ultimate determinant of your long-term financial success for the following reasons:
- Rich people can be "cash poor"
Liquidity issues can lead to bankruptcy for businesses and individuals, even when the value of their assets comfortably exceeds their liabilities. The issue is whether or not those assets can be readily converted into money to pay current expenses.
An example would be a family that owns a very expensive home but does not have a substantial income or savings. The value of the home doesn't do this family much good if they cannot readily access enough money to pay their property taxes and the other routine expenses associated with owning a home.
So, while a high net worth is desirable, it is also important for that value to be appropriately balanced between long-term investments and liquid assets that can be accessed when needed.
- Here today, gone tomorrow
Another aspect of long-term wealth-building that is not necessarily captured by net worth is stability. In particular, people who have a great deal of their wealth tied up in a single asset may be subject to large fluctuations in the value of that asset.
You see this often with entrepreneurs who have started a company, and that company represents the majority of their net worth. That net worth may be a little misleading because the company's value may depend greatly on the founder's continuing involvement, making it difficult to cash in on this type of wealth.
The dilemma is that diversifying your wealth can make your net worth more stable, but it can also water down your investment returns. However, if you have built net worth via a concentrated holding, it is advisable to seek ways to diversify over time.
- Earning power…
Imagine two 40-year-olds, each with a net worth of about a million dollars. However, one is a recently retired athlete who has not made plans for a second career while the other is an executive earning a quarter of a million dollars a year.
Obviously, the millionaire with continued earning power is in a much better position financially. In a sense, wealth isn't just about the value of what you own right now, but it is also a function of your future earning power. This becomes an especially important concept to understand for retirement planning. Even if your net worth looks good on paper, it is important not to give up your ability to earn a living too early, because this is an important component in sustaining wealth.
Also, if your retirement plan depends on you earning a certain income for a specific number of years, create a Plan B -- for instance, a disability policy in case you can't work as long as you might expect.
- ...Versus burn rate
Once again, imagine two different millionaires. This time, one has a fairly modest lifestyle that entails spending less than she earns. The other has developed more expensive tastes and burns through money as fast as it comes in.
The key difference is that the first millionaire is continuing to grow wealth while the second one is more or less treading water and could see her wealth erode if her income diminishes.
The concept of burn rate is very important for retirement planning. There is no one-size-fits all answer to the question of how much money you need to retire. It depends greatly on your spending and whether your wealth is sustainable given the rate at which you spend money.
- Leverage can giveth and taketh away
As the name implies, net worth is a measure of the value of your assets minus the level of your liabilities, which for most households would be debts.
Using debt can help you build wealth faster by increasing the amount of money you have available for investment, but using too much debt increases the riskiness of your net worth.
Think about a millionaire with no debts on the one hand and another who has $10 million in assets and $9 million in debt. On paper, these two each have a net worth of a $1 million, but the millionaire without debt is in a much more stable position. A mere ten percent decline in the value of the second millionaire's assets would be enough to wipe out his entire net worth.
Net worth is a snapshot of your current financial status, but your long-term financial success is dependent on a process with several moving pieces. So, when assessing your financial well-being focus not just on your net worth but on the things that are likely to affect that net worth in the years ahead.
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