Net-Worth – More Than A Number?
Is net worth really a definitive measure of financial success?
It turns out there is more to net worth than a number. The nature of both your assets and your debts can also go a long way towards determining your financial status.
Starting with asset value, it is important to remember that any valuation is just a snapshot in time. How useful assets actually prove to be depends on much more than any one-time valuation:
1. Stability of value. Assets prone to large fluctuations in value should be viewed as less reliable measures of wealth than more stable assets because their value may be very different next year than it is today.
2. Liquidity. To be truly useful, an asset does not necessarily need to have the immediate liquidity of a savings account, but it should be something that can be sold on demand for something close to its assessed market value. So, for example, a portfolio of heavily-traded and publicly-priced stocks is a more useful asset than a private art collection for which the market is uncertain.
3. Income production. An asset generating a steady stream of income is more useful than one that is essentially dead money on a ledger.
4. Growth potential. These days income production can be hard to come by, but growth potential can be an important alternative. Assets that appreciate in value can hold their own against inflation and create more wealth.
5. Investment vs. lifestyle. Growth and income characteristics determine whether an asset is an investment that will produce additional value in the future. This contrasts with what may be thought of as lifestyle assets like an expensive car, which has value today but is not likely to produce more value going forward.
Characteristics of debt
Like assets, debt is defined by more than a simple dollar figure. Whereas with assets, the question is one of how useful they are in the long run, the important thing about debt is how manageable it is. This depends on several things, including:
1. Payment schedule. Even if your assets outweigh your debts, an onerous debt payment schedule can create cash flow problems.
2. Interest rate. Debt should be measured not just by its size, but by how expensive it is to service. After all, credit card debt at 20 percent interest is a much more expensive liability than a mortgage at 4 percent.
3. Stability. Variable interest rates create much more uncertainty and the potential for making debt more expensive to service in the future.
4. Term. Debt that is on track to be retired soon is less of a factor in your financial well-being than debt you are going to have to live with for many years to come.
5. Asset offset. Debts like mortgages that are directly offset by assets create less of a drain on wealth than debts produced by short-term consumption.
The relationship between assets and debt
Net worth is simply asset value minus debt balances, but is that all there is to measuring wealth? Keeping in mind that asset values can vary and debt burdens can become more onerous with changes in interest rates or income status, the way that net worth is constructed does make a difference.
Consider two people who each have a million dollars in net worth. One has $2 million of assets offset by a million dollars of debt. The other person has a million dollars of assets with no debt. Outwardly, the first person may appear wealthier because he has more assets. However, a strong argument could be made that the second person is more secure financially because of not having the liquidity demands or interest rate risk that debt creates.
Both assets and debt can vary in character. This means net worth does not necessarily give a definitive measure of your financial well-being. Assets are most useful when they are productive in terms of growth or income, and can be made liquid on demand. Debt is most manageable when interest rates are low and stable, monthly payments are affordable and the borrower is following a clearly-defined schedule towards paying it off.
Finally, it is not enough for assets to simply exceed debts. Large debts have a way of becoming uncontrollable, so minimizing debt is important to matter how much asset value you have to offset it.
Tell us: How do you measure your net-worth?
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