Monday, March 12, 2007

Why Net Worth Is A Poor Measure of Wealth

Author: Nick
Category: Money
Topics:

Abacus by michelini - sxc.hu/profile/michelini

Ask any person with a modest level of financial education the question “How wealthy am I?” and you should expect the following question in return: “What’s your net worth?” That’s because net worth is the most commonly recognized measure of wealth. And it’s perhaps the easiest the calculate:

Net worth = Sum of all assets – Sum of all liabilities

It seems to work pretty well, too; few would argue that a person with a net worth of $327 million isn’t wealthy, and just about everybody would have a hard time applying the same label to a person with $100,000 in credit card debt and not a penny in the bank. Since the invention of money thousands of years ago, net worth has been seen as an accurate way to determine if a person is rich, poor, or somewhere in between.

How dare I pose such a headline to this article when even the IRS sees fit to use net worth as the measure of wealth? My reasoning for claiming that net worth is a lousy way to determine your wealth is simple: money is only a small part of one’s total wealth picture.

Let that soak in for a minute. Okay, a minute’s up. Time to shock the daylights out of you rich people: having a high net worth does not make you wealthy. Oh, and I have some good news for you low net worth types: having a low net worth does not make you poor.

I’ll give you some examples of what I mean when we play America’s fastest growing wealth-analysis game show…


which person is richer?

Let’s learn a bit about today’s first two contestants on Which Person Is Richer?:

  • contestant 1 - single motherContestant #1 is a single mother working two jobs and going to nursing school part time. She’s ridden with credit card debt, but she’s working hard and has a plan that’s put her on track to be debt free in just a few years. Net worth: -$33,000.
  • contestant 2 - poor boy from burundiContestant #2 hails from Ngozi, Burundi, considered by many to be the poorest country in the world. He has no home, no job, and he often doesn’t know when he’ll get his next meal. But at least he’s debt-free! Net worth: 25 cents.

Now it’s time to see how our studio audience voted when we asked them which of our two contestants is the richer person:

which person is richer? contestant 1 - 91, contestant 2 - 9

Aw, that’s a shame. I guess you can’t be richer than anyone when you don’t have two sticks to rub together. What do we have for today’s winner, Johnny?

Today’s winner will go home with a lifetime supply of rice! Rice–it may be tiny, but it can keep you from starving to death!

Thanks, Johnny. I’m sure our contestant from Burundi could’ve really used that rice, too. Oh well! Let’s meet our next two contestants:

  • contestant 1 - dictatorContestant #1 is a multi-millionaire dictator of a small Central American nation. Most of his family has been killed in assassinations or rebellion attempts. Now he’s fleeing for his life, spending every night in a different Motel 6 to hide from his enemies. Net worth: $85 million.
  • contestant 2 - family manContestant #2 is an upper middle class American family man. He’ll be turning 40 next month, he has $100,000 in the bank saved for his kids’ college, and his 401(k) just hit $300,000. He’s in perfect health, and he loves his life! Net worth: $520,000.

Wow, that’s quite a life you’ve been living there, Contestant #1. Let’s hope you make it out of our studio alive! And speaking of studio, we asked our studio audience to decide which of these two contestants is richer, and here’s what they said:

which person is richer? contestant 1 - 17, contestant 2 - 83

Ouch! Looks like having millions of bucks can’t buy happiness for poor Contestant #1. What do we have for Contestant #2, Johnny?

It’s a free session of plastic surgery! Whether you want to look ten years younger or just hide from the people trying to kill you, this plastic surgery is sure to change the way you “face” the world.

Ha ha ha! Looks like that’s all the time we have today on Which Person Is Richer? Tune in next time when we find out who’s richer: a hunchbacked circus clown or MC Hammer.


Hopefully you get my point by now.

Certainly these are atypical cases, but they are instances where the net worth model of wealth determination completely falls apart. If using net worth to compute richness fails so badly some of the time, it’s reasonable to assume that it might have some shortcomings for the rest of us.

Tomorrow we’ll look at my proposal for a more appropriate assessment of one’s financial status that I like to call the Total Measure of Wealth™.

(Trademarked for when I score a book deal out of this.)

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