Thursday, January 3, 2008

why net worth is not worthless

A few days ago a fellow blogger brip blap posted a well thought out article on his blog called net worth or worthless. Basically the article desribes brip blap's opinion that the personal finance metric, net worth is worthless and 'Net worth is a very difficult number to analyze, and the difficulty in analyzing it makes it a somewhat worthless tool for measuring progress in your financial life.' Having a differing opinion than Mr.blap, I thought I would rebut the idea that net worth is worthless with a rather lengthy post. Please bear with me, because after all, if I thought the metric was worthless I would not bother tracking it bi-monthly.

brip blap laid his argument out in a series of points which he numbered. I'll reiterate Mr.blap's point briefly before I give my case against the point. If you want more detail on brip's points, please visit his blog, which is by the way a good read.

1. You don't know how it's calculated
I feel that not knowing how individuals are calculating a metric, does not in itself make the metric any less useful. It just means the calculation method should be standardized. Let's suppose for a minute that 3 people were asked to determine their body height. The 1st person stood against a wall and awkwardly ran a tape measure up the wall and determined her height in inches. The 2nd person knew that his rug was 5 foot 6 inches across so he laid across the rug and measured the difference, while the 3rd person looked on his drivers license which was listed in centimeters because he was Canadian. So these 3 people used differing methods to determine their own height. Whether any of them arrived at their correct height is unknown. What is surely known is that their height is a relevant metric that can be measured and is certainly useful; just ask Shaq. Perhaps they should all be sent to their doctor to measure their height to the utmost accuracy. This method could be made to be an agreed upon, standardized method by using the same doctor and the same tools.

Also, of course one's home equity is an asset. This argument alone is probably fodder for another post but it seems really simple to me. If I own a $300,000 home outright but have $0 in other assets is my net worth $0? Of course it's not it's $300,000 because today I could sell the home, rent an apartment, fill the bath tub up with my new found cash and jump in....

2. A net worth of $200,000 means different things in a small town in Texas and in La Jolla, California.
I can't say I've ever been to La Jolla California, but it sure sounds nice (I think I've seen it on that show The House Wives of Orange County.) La Jolla sounds especially nice considering that I pumped gas today without gloves on and I couldn't wait for it to be over. I fail to see how where you live makes your net worth irrelevant. If you were able to ante up for a mansion in La Jolla, then good for you. You probably have more financial horsepower (potential earnings) than I do here in lowly old Brantford. Let's say my net worth was $200,000 and my friend Joe who incidentally lived in La Jolla had a net worth of 200K as well. How is this dollar figure any different? Who is better off Joe or me? A net worth of $200,000 can't really generate a substantial income no matter where you live. I might have a $200,000 house with a $100,000 mortgage and $100,000 in the bank while Joe has a $800,000 house with a $600,000 mortgage and $0 in the bank. I'd still say we both had a net worth of $200,000, and it's fair to say that we are on equal footing net worth-wise. Joe might pay more for an oil change than I do, but who cares, he chose to live there, his property value is higher, and he probably has a nice what? We both have the same opportunity to grow our net worth, and his dollars are worth the same as mine....well maybe his greenbacks are worth slightly less than my loonies but you get my point.

3. Net worth doesn't accurately measure cash flow generation
Correct, it does not, that is why it's called net worth. A compass does not accurately measure velocity either....move on.

The money that is present in net worth always has the potential to generate cash flow. At any time every dollar one owns can be coverted into common shares of General Electric (GE). GE will pay you approximately 3.4% of your money annually in cash.

4. Net worth also doesn't show risk
Again correct, but really why should it? Net worth also does not slice, dice and make julienne fries but it's only a personal finance metric. You could make it show risk by assigning a risk value to each asset and weight it all. Personally I think that is a bad idea because most people can't agree on a good definition of 'risk' anyway....

Overall I do not think net worth is the 'be all and end all', but I do believe it is the best tool we have to measure our financial health and progress. I don't care how you look at it, net worth is always meaningful, and improving one's net worth is always a financially positive action.


Traciatim said...

I propose that the net worth be the sum of all assets that can have a monetary value, minus all liabilities. It's as simple as that. You should have your house, and your mortgage too. Even your car if you own it, and any loan outstanding. Just everything.

There should be a Net Wealth figure that is:
Net Worth / (Age^2)

That way someone who is 65 needs slightly more than 10 times the net worth of someone who is 20 in order to have the same 'net wealth'. I think that would give a good indicator of where someone is financially depending on their current age and the amount of time they have had to accumulate monetary worth.

Now if only we could measure human decency and morality the same way, life would be so much easier.

FourPillars said...

I love this post - I'm going to Stumble it.


Thicken My Wallet said...

If you use the same assumptions in calculating net worth then it is a true way of measuring progress (assuming that your assumptions are not off base or cannot be supported by any valuation known to an accountant).

Having said that, I have never agreed with using market value of your home in net worth. Its too subjective; your neighbors home may have sold for a lot because they were shrewd negotiators, had marble counter tops in the kitchen, had the home staged etc. A home should be valued at book value.

As for the net worth vs. cash flow discussion- the curse of Rich Dad Poor Dad is that he has taught a generation of DIY investors to mix up assets/liabilities and statement of cash flow.

traineeinvestor said...

I fail to see how "net worth" (however you chose to measure it) can fail to be a useful measure of financial health.

The fact that different people measure it differently (of artificailly exclude certain items) and the fact that there are other relevant factors to be taken into account does nothing to detract from the relevant of "net worth".

As examples:

1. an adjustment to take into account age (as mentioned by traciatim above)

2. an adjustment to take into account employment income and age (as popularised in The Millionaire Next Door)

3. expressing net worth relative to expenses to obtain an indication of how long a person would be able to get by if unemployed

Brip Blap said...

First of all, I'm glad that my post inspired such a lengthy response! I'll just make a few brief comments since I've got my original article making most of my points.

1. You're assuming all 3 people measure head to toes. What if one person defines "height" as their height including their shoes? What if the next defines height as their height when sitting down? etc. If everyone agrees on the definition of height, fine. With net worth, people don't agree.

2. I am not sure how someone with substantially higher costs of living has the same opportunity to grow net worth, but OK. If you live in a low-tax, low-cost area and have a net worth of $200,000 - let's say American states like Tennessee or Texas or Florida with no state taxes on capital gains - and invest in stock ABC with a 6% return, you will get wealthier than Joe in a high-tax, high-cost area like California or New York or Massachusetts. Joe is taxed heavier on his gains and spends more of the proceeds on higher costs.

3. True - however, you cannot just convert your entire holdings to GE and get a 3.4% return. The first few years of returns will be offset by capital gains taxes paid selling off all of your previous holdings.

4. People don't agree on 'risk' so it's a bad measurement - agreed. People don't agree on 'net worth' so it's a bad measurement, too. Both have exact economic and accounting definitions, but as used by laypeople they are not good, standard points of measurement which are agreed on, like "my weight."

Those are some specific points of rebuttal, but I hear your argument and of course if you feel it's a useful metric, use it, and as I said I'm glad that you continued the conversation! - Steve

MG said...

1. No I’m not, I don’t care what they measured. That still does not make ‘ones height’ irrelevant. I agree with you that people measure it differently, but does that negate to metric for those that measure it accurately, I think not.

2. Taxes might be different but within North America it should all come out in the wash when you tie in all other factors, money is money.

3. What if your previous holding was your house that you sold privately….

4. I think net worth is more specific than risk. By the way though, people measure risk all them time. Risk is also valid if it’s agreed upon as to what the definition is.

I’m glad you brought it up….


Thicken My Wallet said...

I am not sure whether to post here or to Bric Blap's blog but...let's separate the apples to oranges argument I believe both of you are making.

1. If you are using net worth to compare yourself to others than I agree with Bric Blap - the valuation methods have to be the same and if they are not then the value of the comparison is greatly diminished. Thus, Million Dollar Journey's post on comparing the net worth of bloggers is extremely interesting but, ultimately, has some large issues given that the assumptions of what constitutes one's net worth is different for each (which is not to diminish the entertainment value of the post). If this is what Bric Blap is arguing, then the assertion is true- the comparisons are not relevant.

2. However, for personal metrics, if you use the same underlying assumption of measuring net worth (assuming again the valuation method is within GAAP) then measuring your own net worth over time is a very useful exercise.

If that is what the both of you are respectively debating then you are both right since you are looking at the argument at different angles.

Dividends4Life said...

MG: Excellent post. Sure net worth means something. I have to believe the BB was just stirring the pot to generate interest. Your points were well made.

Best Wishes,

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