A subject I frequently see discussed online when it comes to personal finances is what is the correct way to calculate your net worth. In fact, heated arguments often follow this question, in which people will fervently argue that their way of doing the calculation is the only way that makes any sense.
As someone who works with numbers and trying to make sense of them on a daily basis, I can confirm that this is not something that is unique to discussions which revolve around personal finance topics. People all too often get hung up on absolute numbers, without giving much thought to the context from which the numbers come. Numbers have no meaning without proper context.
Consider the following anecdote:
Person A: “My net worth is ten.”
Person B: “Ten what?”
Person A: “Ten thousand dollars.”
Person B: “Nice, but you are a long way off quitting your day job.”
Person A: “Actually, I plan on retiring in just two years.”
Person B: “With that little money? You will be going bust within a couple of months.”
Person A: “I don’t think so. I have quite a bit of equity in my house, which I plan to liquidate, and I have a 70% guaranteed pension, too.“
Sure, the anecdote is very simple, but hopefully it gets the point across. When we first hear the number ten, we have no idea what it means. Most people will then try to understand the number in some way, by unearthing some context. In this example, the first layer of context is the currency and denomination of the number, which is good to know. We now know the absolute number.
Unfortunately, many people consider that sufficient context to start evaluating the number and assign meaning to it. What happens at that point, is that our minds, magical as they are, start filling in the missing pieces of the picture. Lacking the required nuance to understand what is presented, our brain uses our previous experiences to fill in the blank spaces, in an attempt to make sense of the whole. And instead of trying to understand the meaning of $10,000 in the context of which it originated, we give it meaning based on our prior experiences with numbers in that range. Some may be thoroughly impressed, while others again with entirely different perspectives, will be underwhelmed.
The point of this exercise is to hammer home the notion that numbers are meaningless without specific context. This realisation, then, has implications for how you should calculate your net worth. Or, rather, it means that the how you calculate your net worth is less important than the fact that you are clear about why you choose to do it one way or another.
Calculating Your Net Worth
Circling back to the actual exercise of calculating our net worth, doing it in its simplest form is extremely straightforward: Add up the value of all of your financial and material possessions, subtract all your liabilities, and the result is your net worth. The disagreements mentioned in the opening paragraph stem from what is relevant to include in your net worth calculations. As I have now attempted to illustrate, those discussions matter little: What is important is that you calculate your net worth in a way that makes sense and gives meaning to you.
The idea behind the concept of net worth is to show how much money, or rather, purchasing power, you would have if you sold all your assets and fulfilled all your debts. The higher your net worth, the freer you are to live your life the way you want unless you subscribe to the philosophy of the late, great thinker Biggie Smalls, who coined the phrase “Mo money mo problems.”
For most people, the actual value of their net worth number comes from observing how it develops over time. If you can increase net worth reliably and over time, it means you are managing your finances well, and are on the path to greater freedom. If your net worth keeps sinking, you are going down the wrong path and need to make adjustments.
Points of Consideration
Knowing that the aim is to calculate a number that makes gives you information about the state of your personal finances, and to what degree you have the freedom of choice to live the life you want, we can make some assumptions about how to calculate your net worth.
Do I include my house in my net worth calculation?
There are two schools of thought when it comes to whether or not your house should be included in your net worth calculation or not: One that says you should include your home in the estimation, and one that says you should omit it. The idea behind leaving it out is that your house is not an investment that will yield returns, but instead a covered necessity that incurs further expenses in the form of maintenance, taxes and so forth.
I take issue with this point of view. A somewhat non-conventional, but pervasive perspective these days within the online personal finance community is that renting is better than owning. Whether or not that is the case, I do not intend to discuss here. But, it does stand to reason that as long as you accept renting as a viable alternative to owning your home, the equity in your home should naturally be considered a part of your net worth. Liquidating to rent will always be an option, just as downsizing or moving to lower cost to extract partial equity is another.
Whether or not your house will be a sound investment is a different discussion altogether, and it is that question that is at the root of the rent versus own debate. However, if you are a homeowner, it makes sense to include the value of your home in your net worth calculation. That said, if you plan to live there for the foreseeable future, and have no plans of cashing it, it doesn’t particularly matter, as you should adjust you target net worth according to what you choose.
What about my car, do I include that when I calculate net worth?
Same considerations as above, with regards to your house. I stand firm on the perspective that you should include all assets which can be liquidated for a reasonable value in the calculation.
I have a pension, does that add to my net worth?
Well done on securing a pension, and boy does it! Calculating the real value of a pension to add it to your net worth can be complicated, and it is a topic I intend to tackle in a future article. In the meantime, I suggest you take a look at this article from Financial Samurai that looks at how to determine the value of a pension.
My general idea is that if you own it, you include it. There are many other tangible and less tangible assets out there that can be difficult to decide whether or not they belong on your personal balance sheet. If you have a specific question that you need help with, whether it is whether or not to include something, or how to calculate its value, feel free to use the comments below to ask it. I am also open to questions over at Twitter @Abovare, and our Facebook Page.
Header photo by Hermann Kaser.