Now that we’ve established that net worth is inadequate for wealth determination and have come up with a suitable list of alternative wealth measures, it’s time to start looking at each of the criteria and put together a new formula for deriving one’s Total Measure of Wealth™. (Seriously, where’s that book deal??? Don’t make me trademark more stuff.)
Today we’ll start covering the easy stuff–the keys to your Total Measure of Wealth that already have established, standard metrics associated with them.
For those who haven’t touched a calculator since grade school, we’ll start off easy. Your age is how old you are. It’s the number of years between today and the day you were born. I could say more about this, but a long paragraph here might confuse you into thinking this is more complicated than it really is. Oops, too late.
How to Calculate It
If you don’t know your age, ask somebody who does. Or just assume that you’re 37.
How to Use This Number
Despite its extreme simplicity, age is perhaps the most important factor in determining your Total Measure of Worth. That’s because age is the factor over which you have the least control. In fact, you have no control over your age until you build a time machine, and I just don’t see you doing that anytime soon.
Age can mean the difference between a bright financial future and a hopeless financial meltdown. $100,000 does a lot more for a 20-year-old who has a lifetime to invest it than a 65-year-old retiree who must spend it to survive. Age won’t tell you too much about your wealth picture alone, but you’ll see shortly that it can have a big impact on the other measures of wealth.
Net worth has long been the de facto standard of wealth determination. If my net worth is higher than yours, then I am richer and you are poorer. But how can we say that a starving orphan with a net worth of zero is richer than a person with a home, a job, and a promising outlook but who currently has a negative net worth due to a few thousand dollars in student loan debt?
While net worth can’t demonstrate wealth on its own, it is still suitable as a snapshot of your current financial status. It is even more useful when compared to your historical net worth calculations; a rising net worth may suggest smart financial decisions, while a plummeting net worth could indicate out-of-control debt or rapidly depreciating assets.
How to Calculate It
There are really two parts to any net worth calculation: instantaneous net worth and historical net worth growth. Computing your instantaneous net worth is simply a matter of tallying up all of your assets and subtracting all of your liabilities:
Historical net worth growth is a little trickier to compute because you must decide over what span of time you would like to calculate your net worth’s change. On the one hand, we’d like to look at data over a long period to see how your finances have progressed over the years (and maybe decades). On the other hand, long-term data might not place enough emphasis on more recent smart (or stupid) financial transactions.
Let’s start with a look at your long-term net worth change. How far back should we look? That depends on how old you are. Older people have more financial history and should look back further than younger people. For now, we’ll set up a rule of thumb stating that long-term net worth is over the course of the last one-third of your life. So simply take your age, divide it by three, and compare your net worth from that many years ago to your net worth today. (If you don’t have exact figures from that long ago, just estimate.)
For example, since I’m 24, my beginning date would be:
Once we have our dates set, we determine our rate of change:
Now we need a short-term net worth change formula. Let’s say that the short term is fixed for everyone and just looks at your net worth growth over the last year.
How to Use These Numbers
You should view your instantaneous net worth merely as an indicator of where you are financially today. Without the change rates, there is no way to tell based on this number what you should start doing differently, if anything, with your money. Then again, if your net worth is a few million dollars or more, you could try writing me a check.
The long-term and short-term net worth growth figures are much more useful to us. The long-term change provides a summary of how you have handled your finances over the years and indicates what sort of net worth goals you should set for yourself in the next stages of your life. The short-term change lets you know if you’ve made any dumb mistakes lately.
You can also annualize your long-term change rate and use it as a starting point for setting future net worth goals. Simply divide your long-term net worth growth by that age-divided-by-three number to get your annualized long-term net worth growth rate.
So if you’re 24 and your net worth tripled (i.e. increased by 200%) over the last 8 years, your annualized long-term net worth growth rate is a healthy 25%.
While some may argue that maintaining a steady long-term growth rate is a smart goal, I’d like to see my rate increase every year. Comparing your short-term net worth growth to your annualized long-term growth rate will tell you if you’re hitting your target of meeting or beating your growth rate each year.
Tomorrow we’ll look at the other three “easy” wealth indicators: income, savings rate, and rate of return.