Hopefully you have calculated your net worth. Now you might be asking yourself, “What does it mean? Is the number I calculated for my net worth good or bad?”
As a financial scoreboard your net worth is useful but limited. It’s like having your score on the scoreboard, but not your opponent’s score. It provides some useful information about your financial situation but doesn’t show if you are winning or losing. For that you need more information.
Tracking Your Net Worth Over Time
Tracking your net worth over time helps provide the answer. Personal finance is an individual sport, like running. In competitive running races “weekend warriors” often run in the same events as world class athletes. If you compare yourself to those at the top you are destined to be disappointed. While you might want to beat as many of your fellow competitors as possible what you are really trying to do is “beat yourself.” If you can set a “Personal Record (PR)” – run the required distance faster than you ever have before – you can be pleased with your performance no matter where you finish in the standings. The goal is to continually improve.
The same is true with your net worth. If you compare your net worth to the wealthy you are bound to be disappointed. On the other hand, if you concentrate on making wise financial decisions, and compare your current performance to your previous performance, you will see improvement over time. This improvement will give you the motivation to keep trying. Your goal is to try and establish a new net worth PR each time you measure your net worth. This is also why you should limit how often you calculate your net worth to no more than quarterly. More frequent measurements do not give your decisions time to make a measureable difference.
Comparing Your Net Worth to a Standard
In running races there are numerous categories or divisions. There is usually an “Open Division” reserved for the top competitors. In addition, there are various “Age Group” divisions for both men and women. This creates many separate competitions within the main race, and awards are given out not only for the top overall finishers, but for age group winners as well. The idea is to group runners with others that have similar characteristics. While your goal might be a PR it is also interesting to see where you finish in your division. Your standing within your division can provide valuable information about your progress.
Net worth measures how efficient you are at turning your income into wealth. Comparing your net worth against someone with a much higher income, or someone much older than you, would be like comparing your running time with that of a world class athlete. It would depress you without providing any useful information on the progress you are making.
Dr. Thomas J. Stanley and Dr. William D. Danko, in their excellent book The Millionaire Next Door, developed a method in which you can compare your net worth to a standard of what might be expected by someone of your age and income. Their method, in essence, establishes net worth categories where you can compare your net worth against others in similar circumstances. Stanley and Danko developed the following simple formula to accomplish this:
(Age of primary household breadwinner X total household income)/10 = desired net worth
For example, if you are 50 years old and your household income is $100,000 the calculation would look like this: (50 X $100,000)/10 = $500,000.
Stanley and Danko further stated that if your net worth is less than half this amount you are an Under Accumulator of Wealth (UAW); if your net worth is anywhere from half of this amount to double this amount you are an Average Accumulator of Wealth (AAW); and if your net worth is more than twice this amount you are a Prodigious Accumulator of Wealth (PAW).
Using the example above of a 50-year old earning $100,000 the categories would break down as follows:
UAW = Net Worth of Less Than $250,000; AAW = Net Worth of $250,000 to $1,000,000; PAW = Net Worth of Greater Than $1,000,000
Here is a link is to a webpage that will perform this calculation for you if you enter in the relevant information. It will also tell you what category you fall in. Take a couple of minutes and give it a try:
This method is simple to use, but it does have some limitations. For example, it doesn’t work well for the very young. Also, if your household income recently increased significantly, which is a good thing, it will make things appear worse than they are. In that case you might want to use a three-year average for your household income in the calculation. In spite of these limitations I think it is a useful exercise to compare your net worth against this standard every year or two.
Concentrate on the Things You Can Control
When training for a race you might suffer an illness or an injury. When trying to come back from a setback like this you might be doing everything right but still not be anywhere close to a PR. In these cases you shouldn’t worry so much about the PR. Instead, concentrate on the things you can control like treating the illness or injury, your training program, and your diet.
The same is true with your net worth. For example, over the past five years my wife and I have done a lot of things right. We have paid off a significant amount of debt and saved and invested more than ever before. In spite of this we have struggled to keep our net worth steady. The reason is the housing crisis, which caused the value of our home to shrink considerably. This can also happen if your investments go through a bad stretch. If all you concentrate on is the bottom line net worth number this can be depressing. The key when suffering financial injuries like this is to concentrate on the inputs to your net worth that you can control, such as paying of debt and your savings rate. Over time the other things will even out and you will be fine.
Using the information above will help you understand what your net worth means. This knowledge will help you make wise decisions as you strive to improve your financial situation over time.