This month’s Net Worth Update is a combination of my progress (scroll to the bottom) and thoughts on the major drawbacks of tracking net worth.
I’ve always liked reading other blogger’s net worth updates. For one thing, it helps me establish credibility. If I don’t see strong progress month to month or a high savings rate, I find it difficult to consider their advice seriously unless they’ve demonstrated the successful application of their methodology in some other way. If the results speak for themselves, I’m all ears. Moreover, I’m competitive and like to use results from other 20-somethings as a benchmark.
However, the month to month net worth increase is a flawed metric and is limited in its usefulness.
A net worth update is a snapshot of what you have at any given moment in time. Essentially, it’s your personal balance sheet. Does the change in net worth reflect your true progress month over month?
Would you invest in a company based solely on their historical balance sheets? Sure you like to see book value growth, but what if it’s all coming from one-time earnings! I certainly wouldn’t judge performance on that measure alone.
Results can be swayed by factors beyond your control
This is extremely topical right now with the volatility in the markets. If you have substantial investments, +/- 5-10% swings in the market in either can outweigh any incremental savings you are able to put together over the course of the month and obscure your true progress.
If you’re net worth is down month-to-month because of market fluctuations, but you managed a 40%+ savings rate. You should be proud of what you’ve accomplished.
On the other hand, bull markets can cause increases in your net worth well in excess of your true contribution and create over-confidence. During the U.S. housing bull market, people used rising home values to take out second mortgages. Even though spending was well in excess of spending, family net worth’s were rising! Evidently, the composition of that increase in net worth proved unsustainable. Tracking net worth progress would not have prevented this type of behavior.
Double Counting Returns
I also have a fundamental objection to counting non-employment income as part of your earnings. Ie: As far as I’m concerned, if you earned net employment income for the month was $5K, received an additional $1K in rental property income, and spent $3K, your savings rate is 40%, not 50%.
Why should you exclude investment income? Well because most retirement calculators assume a fixed amount of savings per month with compounded returns on the savings. Over time, the bulk of your period to period net worth increases should shift from savings to returns.
If you’re doing it right, your net worth over time is a non-linear function. Say, your normalized (normalizing returns) net worth increase is higher this month than the same time last year! Great, does that mean you’re on or ahead of track for retirement? I don’t know – is the increase lower or higher than it should be, ie: what’s the second derivative of your net worth relative to where it should be? – Looking at the wrong metric can make it difficult to derive the appropriate conclusion.
In other words, you shouldn’t count rental or investment income because it’s not money that you earned this month. It’s the return on the savings you’ve accumulated or previously already earned. That’s typically already accounted for in retirement calculations.
The Solution – Focus on SAVINGS / CONTRIBUTIONS
The most important figure to focus on each month is the amount saved and contributed to various accounts or debts repaid. This is a true measure of how you are progressing and is unaffected by wild swings in the market. While it feels good to see my net worth figure below increase, the figure I’m most focused on is the additional savings line.
Net Worth Update for October 2nd, 2011- Age 22
Assets:
Cash: 4,938
Non-registered investments: 10,202
TFSA: 9,026
Employer Stock: 1180
Loan to a friend (1258 principal with a 25% haircut): 943
Liabilities:
None
Current Net Worth: 30,146 (+7.03% month over month)
Previous Month Net Worth: 28,164
Change in Net Worth: 1,982
Due to Additional Savings: 2,997
Savings Rate: 64% (59% including haircut)
Due to Haircut on Loan: (236) – There is little/no repayment risk here, I’m simply marking it down to reflect timing uncertainty and opportunity cost
Due to Investment Gains (losses): (779)
So the figure I’m focusing on this month happens to be (much) higher than my actual net worth increase. I promise this isn’t just self serving bias! I’m definitely not expecting 10.7% or (70%+ annualized) losses in my TFSA to happen on a regular basis.
