Why your net worth is important

What is net worth?

Your net worth refers to a fairly simple but important calculation. Net worth is essentially the total value of all the things you own less the value of what you owe. If you have more assets than liabilities, your net worth is positive. On the other hand, if your liabilities exceed your assets, your net worth is negative.

What can be considered an asset when calculating net worth?

When it comes to your assets, it’s important to make a couple of distinctions:

Tangible versus intangible assets – A tangible asset usually has a physical form and a clear monetary value. Examples include a home, a business, a factory, diamonds, cash and others. An intangible asset could be something like goodwill, patent rights, licensing rights to books or movies. These may provide income recurring streams however, intangible assets are harder to calculate in terms of absolute value until they are sold or fully realized.

Liquid vs. illiquid assets – Liquid assets are those assets that can be quickly converted to cash if the need arises. An example of a liquid asset is a savings account or stocks that you can sell through your brokerage account. An illiquid asset refers to something that can take a long time to sell. A good example is your family home. Although it might be your biggest asset, it’s unlikely that you will be able to sell it in a day if the need suddenly arises.

Example of how to calculate net worth

Let’s say you have a home valued at $200,000, a car worth $30 000, and furniture worth $25 000. Your gross assets, therefore, amount to the sum of all these, i.e. $255,000. If your liabilities include a home loan of $160,000, a car loan of $25,000, and a bank overdraft of $15,000 it brings your total liabilities to $200,000. To calculate your net worth, simply deduct the total liabilities of $200,000 from the total assets of $255,000. That brings your net worth to $55,000.

If you have a retirement fund, its current value should of course be added to that. For a full personal illustration on determining your net-worth, you can use our handy Net Worth Calculator, which covers most all asset and liability categories.

Why is my net worth of importance?

Your net worth is important because it offers a condensed summary of your financial situation at the present moment. If you look at the $55,000 in the example above, it represents the sum total of every dollar you ever earned minus every cent you ever spent.

For someone who has been working for 20 years and earned around $1 million over that period it can be a wake-up call that, when retirement looms, he or she might not have enough money for their golden years.

While a one-off snapshot of your finances can be valuable on its own, it will become even more useful if you calculate your net worth periodically, let’s say every year. By doing that you will be able to clearly see if your financial health is improving or deteriorating over time. This will also help you to see if your plans to increase your net worth are working or not.

What my net worth should be?

Since everybody’s financial goals and circumstances are unique, it’s hard to establish a one-size-fits-all ‘perfect’ net worth that applies to all of us. Every person should, however, calculate where he or she would like their net worth to be at a specific point in the future, such as the point of retirement.

If you don’t have a financial background, it might make it easier to use the following formula as a ballpark figure:

Net worth target = (Your age – 25) x (20% of your gross yearly income)

Let’s take the example of a 55-year old who has a gross yearly income of $80,000.
The first part of the equation therefore = 55 – 25 = 30
The second part equals $80,000 x 20% = $16 000

A reasonable net worth for this person at this stage would thus be 30 x $16,000 = $480,000.

We are not implying that this is the perfect net worth every 55-year old should have. The formula should merely be used as a starting point. Depending on your goals and lifestyle, your ideal net worth might be much less or much more than this.

Some people may not need to worry about retirement savings at all, for whatever personal reasons. For example, plan to buy a condo in Monaco upon retirement and rub shoulders with the rich and famous every night, you are going to need a much higher net worth than someone who dreams to go ‘off-the-grid’ the moment he or she retires and live in a cabin in the woods.

The topic of asset allocation considerations by age is covered in my article on Asset Allocation Methods for Investors.

How can I increase my net worth?

On paper, at least, the answer is very simple: reduce your liabilities or increase your assets.

[1] Reduce your liabilities

Paying down your debt should always form an important part of any endeavor to increase your net worth. It is particularly important to look at your short-term debt because these interest rates are typically the highest.

For example, if you currently keep your ‘nest egg’ in a money market account where it earns a paltry 1% interest while you have credit card debt or an overdraft on which you pay 12% interest, you will almost certainly be better off by withdrawing the cash and using it to pay off the credit card debt. Of course, you will need a source of emergency funds but that is what a credit card/overdraft is best for. Use these only for an emergency and repay the debt as soon as possible.

Once you’ve done this, calculate how much interest you are saving every year. And then deposit this amount into a savings account to remind yourself how short-term interest can take a bite out of your savings.

[2] Change your spending habits

We highlighted earlier that your net worth today is the sum of all the income you ever generated less everything you ever spent. Let that sink in. Every dollar you spent in the past would still have been part of your net worth today if you did not spend it.

That’s why having a budget that summarizes all your monthly income and expenses is so important. Your expenditure according to that budget can never exceed your income, otherwise your net worth will decline every month.

Study the list of expenses. Do you really need to spend $1,000 a month on clothing? Or on dining out? How much would your net worth increase over the next 10 years if you started saving $1,000 every month?

[3] Invest in appreciating assets

A simple example of what is not an appreciating asset is the family car. Yes, it’s necessary. However, do you really need to drive a $100,000 car instead of a $50,000 one? If you finance both cars at 12% per annum over 5 years, you will eventually pay $133,467 for the expensive model compared to $66,733 for the cheaper one. This is including interest payments. Also bear in mind both will likely be worth a fraction of their list price in 5 to 10 years time.

Appreciating assets increase in value over time. A home is one of the most common examples of an appreciating asset. If you bought your home for $100,000 20 years ago and it’s now worth $200,000, your net worth would now be $100,000 more without you having had to work a single day for it.

A second home or even a small apartment can be an extremely good way to increase your net worth over the long run. The rent on any additional property you buy should easily cover mortgage repayments. When you consider that after 20 years, you will have a fully paid-up property that is worth much more than you paid for it. Furthermore, it will most likely generate a stable monthly income for the rest of your life.

[4] Maximize your retirement contributions

Maximizing your retirement contributions comes with two major benefits. In the first place, it reduces your taxable income because it’s tax-deductible. Secondly, they increase your net assets.

So it’s well worth checking whether they have a retirement plan at your workplace and, if there is, starting to contribute as soon as possible. When it comes to retirement plans, time is indeed money.

[5] Get multiple sources of income

Generating income from more than one source can help significantly to boost your net worth over time. Not only will you be able to pay off your debts more quickly, but it will also make it unnecessary to use expensive borrowed money.

While getting a second job has traditionally been a major way of generating more income, the advent of the Internet has opened up many new opportunities. Nowadays you can open an online store with the minimum of effort at places like Amazon and start selling products for which you have a passion.

There is also a lot of freelance work available online. It will take time to build up a client base, but in the long run, it could become a great way to earn extra money. Money that you should preferably invest instead of spending it the moment it arrives in your bank account.

What are more aggressive ways to increase my net worth?

If you keep your savings in a call account you will most likely not get substantial wealth-building interest on it. However, this is usually a safe investment. If you want to get higher returns on your short-term investments in order to grow your net worth aggressively, one option is to invest in higher-risk assets.

[A] Investing in stocks

An example that immediately comes to mind is investing in stocks. According to Investopedia, the S&P 500 Index is delivering returns of around 7% per year over the long term. That means a balanced investment in a variety of stocks that cover all business sectors can more than double your investment capital over 20 years and significantly boost your net worth.

Of course, you should never invest all your reserves in a single stock. Anything can go wrong with an individual business at any given moment, causing its stock price to plummet. Diversifying will in the long run save you from nearly certain financial ruin. This is why many investors put their money into index funds that reflect the composition of stocks in the S&P500 or NASDAQ.

[B] Investing in art, antiques, and other types of collectibles

Investing in art or collectibles can considerably increase your net worth. You should be aware, however, that the value of assets like these often fluctuates wildly depending on current tastes.

We’ve all watched one or more episodes of ‘Antique Roadshow’ where people discover items (including works of art) in their garage or attic that turn out to be of huge value.

However, to increase your net worth by investing in art, antiques, or other valuables you will first have to study that particular market. Make sure you know exactly what is in demand at the moment, and find out how this demand has changed over the last couple of years. Investing in something that has withstood the test of time and is now as popular among investors as 20 years ago is a much better idea than spending money on the latest fad only to find out a year from now the collectability has dropped dramatically.

[C] Invest in alternative assets such as cryptocurrencies

Allocating a small portion of your net worth to cryptocurrencies is becoming a more mainstream concept over the past few years. Several reputable investment banking divisions are enabling clients to have access to this relatively new asset class. Although owning or trading cryptocurrencies is still risky for many given the price fluctuations, they cannot be ignored in terms of their overall appreciation the past few years and potential to increase net worth.

A mixed approach works to increasing your net worth

Above we’ve mentioned a few conservative ways to build net worth, and also a few more aggressive ways. This does not mean to say it’s a one or the other choice you are facing: either conservative and slow or aggressive and fast.

Seasoned investors often use a formula when making this decision. They would, for example, invest 80 percent of their available funds in relatively safe assets that might not have the highest possible returns, but there is a lower risk involved. The other 20 percent they would invest in a balanced portfolio of higher-risk assets like stocks, collectibles, and artworks. This again depends on the asset allocation method preferred by an individual investor.

Wrap up

Just like the best type of stock market investment strategy is a balanced approach, the best long-term way to grow your net worth should ideally use a mixture of conservative and aggressive strategies. When it comes to more aggressive types of strategies, the professionals still follow a balanced approach. They will virtually never invest all their high-risk funds into a single stock, work of art, or collectible. Keep your eyes open but also weary for any investment that looks too good to be true. You don’t want to risk too much of your net worth on any highly speculative assets.

Net Worth Calculator

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