One key to building wealth is to measure it and track progress regularly.
Just like there’s no way to tell what’s happening in a sporting event without a scoreboard, you can’t determine your success in growing wealth without some sort of tracking.
As a scoreboard is to a sporting event, your net worth is to your financial status. It tells you how much you really own.
Yes, other factors matter (such as income, savings rate, cash flow, etc.) but they only matter in how they impact the key financial measure: net worth.
What is Net Worth?
Before we get deeper into why net worth is so important, we need to define what it is. As a simple equation, net worth can be expressed as follows:
Assets – Liabilities = Net Worth
In other words, if you add up all the things you own (assets like your home, savings, retirement accounts, etc.) and subtract everything you owe (mortgage, loans, credit card debt, etc.), the difference is called your “net worth”. It tells how “wealthy” you are.
Why It’s Important
You know the old adage, “You have to know where you are before you can figure out where you are going”? That is true with your finances too.
The first step to becoming wealthy is to determine where you stand financially — to know your current net worth. From there you can take steps to improve it over time (we will give lots of tips how to do this over the life of this blog). And as you track your net worth through the years, you’ll easily be able to see if the steps you’re taking are having an impact and how much of one.
Knowing and tracking your net worth is your road map to financial success. Thus it’s vitally important that you track it on a regular basis.
How to Track Your Net Worth
There are different ways to track your net worth. You can use the old-school method of a simple sheet of paper, a more modern option like a spreadsheet, or an automated selection like Quicken or Mint. Which option you choose doesn’t really matter. As long as you’re consistent, you’ll be able to determine if your actions are growing your wealth or not.
Personally, I track mine monthly using Quicken. Each month I update the performance of my investments, put in my income and spending, and run a net worth report. I then record it in a spreadsheet and compare it to the other months of the year as well as my goals for the year.
Doing this gives me a quick report card on how I’m doing managing my money and highlights where I might need to make changes. In addition, I record my final net worth at the end of each year (and have done so since the early 90’s.) That’s how I know that my net worth has grown at a compounded annual rate of roughly 14.5% since then.
I used to update my net worth weekly, but that was simply too obsessive — even for me. In addition, there were too many wild swings (up big one week, down big another) as the market went up and down, big bills were paid, etc. Looking at it only once a month seems to level the swings a bit. As such, this time frame works best for me.
Monthly tracking is probably the most frequent you’d want to monitor your net worth (any more frequently doesn’t really give you enough time to see progress.) Others measure their net worth quarterly or twice a year. I recommend that you check it every three months at the very least. Whatever your timeframe, just be sure you review your net worth regularly.
Income is Important, but Not the Key
Before I round out this post, there’s one issue that needs to be addressed because there’s a lot of confusion about measuring wealth.
Many people equate “income” with “wealth.” They are not the same thing. “Net worth” and “wealth” are the same thing.
Obviously having a good income can help you grow your net worth and you should work to make your income as high as it can be IMO (that’s why it’s the “E” in “ESI”.) But your real wealth is what you keep, which means that in addition to earning a lot you need to control your expenses (the “S” in “ESI”).
Another way to look at this is that while having a good income will help you grow your net worth faster, you don’t need a high income to amass a relatively high net worth. In fact having a high income often doesn’t lead to a high net worth. Main reason: those who make a lot tend to spend a lot. If you make a boatload of money every year and spend a boatload plus some, you’re going backwards financially.
The Media is Clueless
Adding to the confusion (or maybe causing it) is the financial media. In almost every article written by the mainstream media, “wealth” is used interchangably with “income.”
I believe this mix up occurs for two reasons. The first is ignorance. Most of the people reporting on personal finances know very little about the subject — at least managing money on a day-in day-out basis. Sure, they might be educated or have read several books on the subject, but they are (generally) not wealthy and as such don’t know the ins and outs of how to grow wealth and track it.
The American public is no better. Most believe that someone making $100,000 a year in income is “rich” while someone making $30,000 a year is “lower-middle-class.” But if they knew that the person making $100k spends $125k a year and the “poorer” person spends $25,000 a year, they might think differently. But Americans rarely consider the expense side of the equation (which accounts for the poor state of finances many have.)
The second reason for confusion is data availability. Income data is readily accessible in large amounts and thus easy to use in articles and posts. It doesn’t make it right, but it’s another likely reason financial media use it so often.
The Bottomline
We will discuss many of these issues in future posts, but let’s summarize to wrap this up for now:
- Net worth is the measure that tells you how wealthy you are.
- Knowing your net worth is important since you can then make changes to improve it.
- By tracking your net worth on a regular basis, you can see your financial progress over time.
- Income is a key factor in financial success as long as spending is controlled. If it is not, income becomes pointless.
That’s my initial primer on net worth. Anyone have anything to add?
Welcome back ESI I look forward to more of this site.
I too track our spending and net worth on a monthly basis; doing so has helped to change a spendthrift spouse into a frugal spouse-another key to developing wealth. For those who wish to retire prior to age 59 1/2 it is important to know as well how much is held in tax deferred accounts such as an IRA or 401K vs. after tax accounts.
I use personalcapital.com to track my net worth on a day to day basis. It links directly to all of your accounts and keeps everything organized. In addition I use an excel spreadsheet to track my net worth at the end of each year. It reads like a balance sheet with detail on all assets and liabilities allowing me to see how I am trending year over year.
We track our net worth monthly. Our goal is to increase our net worth every month. Focusing on increasing our income is the primary tool to ensure growth month after month, regardless of what the market does.
However, I sense there may come a day or inflection point where the swings from our investments may overshadow the contributions we can make due to savings a high percentage of a high income.
The good news is I think we still have at least 5 years of robust growth in income before that becomes an issue.
Great article! For me living in the UK, I have to find an alternative version to Quicken, but they are free stuff out there that I will try and use 🙂 But i have an idea of my net worth by doing some quick calculations 🙂
ESI – I just stumbled across your website and am reading through your many great articles/blog entries. Regarding your definition of Net Worth, I have 2 tax related questions for you :
1) Are you recognizing any future tax liabilities associated with converting retirement assets into taxable income? Stated another way…if the aggregate value of all of your tax-deferred retirement accounts today is $1 million and you think you’ll be in a 25% federal tax bracket when you start to tap into those funds, are you including $1 million in your Net Worth calculations or $750k or some other figure entirely?
2) Similar question pertaining to unrealized gains in taxable brokerage accounts – does your Net Worth calculation include an estimated tax provision for the day that those unrealized gains become realized?
My definition of Net Worth includes estimated tax liabilities for both of the above but I’m curious as to how you’ve dealt with this.
FYI – I regularly track our Net Worth and have been doing a more detailed job of it over the last 5-7 years. It certainly helps clarify how your current finances stack up relative to your targeted financial goals.
Hi, Mike. Thanks for the kind words.
To answer your questions:
1. No, I do not discount assets or add liabilities for taxes. I also don’t add in some plug number for future growth. There are just too many variables to consider/estimate accurately. besides, the traditional definition of net worth is assets less liabilities (existing ones) and I’m a traditional sort of guy. 🙂
That said, I do stray a bit and put in what I’d consider to be known liabilities like paying for our kids’ college educations.
2. No, for the same reason as above.
It’s an interesting thought process. I’ve never seen net worth treated this way (with tax liabilities put in) and wonder what others think of the idea.
52 married with two young kids here. $3.7 million NW, mostly accumulated via savings from a high income job in the last 5 years or so (since an expensive divorce). For the purposes of comparing apples to apples and being consistent across my investment asset classes, I use the pretax numbers. However, I ask myself this question all the time, because (1) I am a geek, and (2) I don’t want to delude myself into thinking I have more money than I actually have. My solution is to take 25 percent off of my expected distributions (using the 4 percent rule) for taxes, when I do my “financial independence” calculations.
Almost 40% of our “Gross” Net Worth is attributable to assets that haven’t yet been taxed – retirement account assets, bonus income from my employer that I’ve been able to defer on a pre-tax basis, and unrealized gains in taxable brokerage accounts. Between the Federal Gov’t and the great state of MN, I’m fairly confident in saying that the probability that we pay no income tax on those amounts when they become taxable income is 0%. So, in lieu of fooling myself into thinking that our Net Worth is higher than it really is, I use our current effective tax rates to generate a “retirement/deferred income” tax liability provision relative to the current value of those accounts. I also “tax” the current unrealized gains that have accumulated in our taxable brokerage accounts by assuming that they all “season” and eventually become Long Term realized gains as opposed to a blend of Short Term and Long Term. Recognizing these deferred tax liability provisions produces a “Net” Net Worth value that is 90% of our “Gross” Net Worth value; a non-trivial 10% haircut. By doing this, I know full well that I’m coming up with a conservative estimate of the future tax impact and of our Net Worth. But at least I’ve built in a provision that recognizes the fact that the tax man always get his cut.
That’s my thought process.
I see where you’re coming from.
For us, we’d simply count taxes as a budgeted expense when (maybe more “if”) we withdraw the funds.
Happy New Year to you all! I am thrilled to have found this website, having just read The Millionaire Next Door, which my husband had been trying to get me to read for years. With all the best intentions, it is very hard to find out how to track income and spending if you are absolutely NOT a numbers person or good with spreadsheets. I use Mint but don’t find it to be that helpful and am confused about whether I should do my partners accounts with mine or separately (he’s the offense, I’m the defense).
Can anyone point me in the right direction please? I have been thinking that maybe I should do a bookkeeping course, or perhaps that would be overkill?
Thanks in advance!
I have used Quicken for over 20 years. Also heard that EveryDollar.com is good for budgeting.
Thank you. I will look into that!