Net Worth: It’s Not the Size that Matters

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Tracking net worth from a quantity, absolute number standpoint is a useful exercise.

In fact, it's a habit I've practiced for >15 years. However, it's far more important to understand the quality and health of your net worth number even more so if you're considering early retirement and buying yourself some freedom years.

Basically, the size of your net worth is ultimately less important than the mix of your assets.

What do I mean by ‘Assets'?

There are endless articles on what defines an asset in a net worth calculation. Since I prefer to keep things simple, and my focus is financial freedom, I'll categorize assets into three main buckets:

Bucket #1:  Home

This is basically the house you live in. To calculate what it's worth, you simply estimate the sell price of the home, and deduct all costs, such as: outstanding mortgage, real estate commission costs, and closing costs. You basically want to price this asset at the net price you would get if you sold the home. The cash you would walk away with if you sold it, assuming you have positive equity. If you don't own a home, and rent instead, this asset bucket would be zero.

Incidentally, if you own your home outright, and have no mortgage, I strongly believe it should be included in your net worth calculation. This is despite not having the ability to generate income from the property while you live in it. Unless you plan on living in a tent on free property, owning your home is an expense avoidance enabler, and therefore a valuable asset.

Bucket #2:  Retirement Fund(s)

These are all the funds you have saved for traditional retirement. This includes 401(k)s, 403(b)s, SEP IRAs, Roth IRAs, and/or pension funds. Basically any fund you have stashed away that is inaccessible, without penalty, prior to a set retirement age.

Bucket #3:  FIRE Fund(s)

These are investments or funds you have set aside to power your Financial Independence Retire Early (FIRE) engine. They act as a bridge to traditional retirement. These investments can range from taxable brokerage accounts to income producing real estate. It could even include business equity. This bucket can also include cash. It's basically anything you have of value that can generate income to cover your expenses and other financial goals during this period. If your goal is not to retire early, this bucket still applies, just cross out the ‘RE' from FIRE.

I often get asked if the above should include things like jewelry, cars, precious art, etc…

The answer depends on why you're tracking your net worth to begin with. If it's a gauge of how much you're worth in absolute financial terms, should you liquidate your entire life, then by all means include those elements. Just make sure you're valuing them realistically. I personally don't include any of those things in my net worth calculation. Mainly because I think it overcomplicates the formula, and in my case doesn't help me reach my ultimate goal.

How Do I Calculate Net Worth?

Based on the above categories, you can calculate your net worth as follows:

Net Worth = [Home + Retirement Fund(s) + FIRE Fund(s)] – [Liabilities]

Liabilities is simply all your debt, assuming you have any. This generally includes: Mortgage(s), Student Loan(s), Credit Card Debt(s), Auto Loan(s), and any other debt obligations.

So once you have your net worth number, and the associated buckets quantified, you have a clear picture of your situation. You can now evaluate the quality of your number, or if you're still growing your nest egg, the desired quality in the future.

Let's look at some hypothetical examples to drive the point home…

Net Worth Mix Examples

We'll use $1,000,000 as a nice round number to run our scenarios, and since I just turned 40, we'll go with that age just to illustrate the point. We'll also use the average household expense level of $48,000 per year from my post on how much income is needed to become a Millionaire. Let's start with some extreme examples using a fictitious Max household…

Scenario 1:  Max-Home Example

In this example Max owns a house that's fully paid off, worth $1M. It's a beautiful house, in a wonderful neighborhood, and it has enough sentimental attachment that Max has no intention on moving after retirement.

Max has spent all his working years paying off his house, and has no other assets to speak of. He's been tracking his net worth, and has an impressive $1M. He's now thinking about retiring early and finds himself in a bit of a jam.

In order for Max to actually retire, he will need to sell his house and convert some of the money into something he can live off. But that means he will need to give up his home. That $1M sure sounded great when he was comparing it to his neighbor's, but now it FEELS like zero!

Scenario 2:  Max-Retire Example

In this example Max has been contributing to his workplace 401k for many years. During this period, he maxed out his contributions, and earned a company match as well. He now finds himself with a nice financial nest egg of $1M.

Max has been with this company for his entire career and is beginning to experience burn-out. He's been reading a lot of FIRE blogs lately, and wishes he could transition to a true FIRE lifestyle.

Unfortunately Max can't tap into his 401k until he's 59 1/2 years old. If he does, he'll incur heavy penalties and reduce his overall financial nest egg in the process. He'll also be putting his traditional retirement at risk since his 401k fund was meant to take care of him past his 60s.

A $1M 401k balance is impressive, but it FEELS like zero. At least for the next 20 years.

Scenario 3:  Max-FIRE Example

In this example, Max has exclusively funded non-tax advantaged accounts and alternative investments over the past number of years. He now has a nice $1M total nest egg, which puts out just enough income to cover his expenses.

He could theoretically retire by using those funds to cover the next 20 years, however his investments could be risky. There's a good chance his nest egg would not be sufficient once he reaches traditional retirement age, especially if inflation rears its ugly head.

Although this $1M nest egg FEELS great, it's not very secure and keeps Max up at night. It's the most flexible scenario for Max to find himself in, since he can do any number of things with the money to adjust. However it's still not ideal over the long term.

Of course few people have a net worth mix as black and white as all the examples above. There are infinite combinations and grey areas when it comes to a net worth mix. The main point I'm trying to make is that comparing net worth numbers at face value is a pointless exercise, unless you really dissect the mix of the number.

How that mix is allocated should reflect your priorities and goals, and ultimately the health of your net worth.

Max Net Worth Strategy

Since my stated goal is to buy as many freedom years as effectively possible, my strategy is to position my net worth accordingly. I believe in a balanced approach, so I'm not willing to compromise traditional retirement, or financial security to get there.

Manage Risk

Any good net worth strategy takes expenses into consideration. It's not just about frugality and living modestly, it's really a question of reducing exposure and risk. The lower you get your fixed expenses, the lower your risk exposure during challenging times. This strategy works equally well during the good times, since your low exposure gives you the flexibility to take on more risk if you're feeling adventurous.

This is why I prioritized paying off all my debt as quickly as possible, including my mortgage. I now have a very low fixed risk profile. I view my home as an asset because it enables me to have that low risk profile since I have no associated payments. My first bucket, the Home Bucket, is essentially filled.

Guarantee Traditional Retirement

Ok, there's no such thing as a guarantee, but you can get fairly close by improving your odds. The way you do that is by filling the Retirement Fund Bucket aggressively and early. Once it reaches critical mass, it will compound on its own until you reach traditional retirement age.

This should be prioritized over the FIRE fund, since time is on your side. If I'm aiming for financial freedom in 5 years, and my retirement fund reaches the right critical mass by then, that gives this bucket roughly 25 years to grow untouched, with no additional funding.

My goal with this bucket is to have enough passive income generated from it by the age of 70 and beyond to cover my desired lifestyle. This bucket is about half filled at the moment, and is on growth auto-pilot.

Get FIRE'd

I mean that in both the literal sense (i.e. firing myself from traditional work) and in the figurative FIRE Fund Bucket sense. Over the next 5 years, I will be positioning myself to exit from the traditional work force. To pull that off successfully, I need my FIRE Fund to cover 25 years of expenses, as a bridge to traditional retirement.

This bucket is my primary focus over the next 5 years. I need to get it to the appropriate critical mass, which I'm still analyzing. I also need to invest it in such a way that it provides the necessary lifestyle during the length of my freedom years.

My best estimate is that this bucket is about a third full at this time. I've ramped up my savings rate to get it completely full in 5 years, barring no changes in income, or premature FIRE detonation.

Net Worth Summary

As I promised in my post detailing my Net Worth Journey, below is the current mix of my number based roughly on year-end 2016 values, and presented based on the approach I just covered:

Bucket # 1:  Home / $550,000 / Full Bucket

Bucket # 2:  Retirement Fund / $600,000 / Half-Full Bucket

Bucket # 3:  FIRE Fund / $450,000 / Third-Full Bucket

Most of my funds are currently sitting in cash. I don't feel comfortable enough to deploy my money and put it to work, because I'm still analyzing my investment strategy. I'm not overly concerned about missed growth opportunity over the next 5 years since my strong cash flow should help keep me on track.

I'm about 15% exposed to the stock market at present, and I'm pretty comfortable with that, at this point in time. The exposure hedges against inflation, and keeps me participating to a limited extent.

If the market gets cheaper over the next few years, I might decide to increase my exposure more aggressively, so far I'm at a gradual pace. Any investing I do will likely be limited to Vanguard Index funds, with a few exceptions I'm exploring.

All net worths are not created equal, and the health/quality of the number is far more important than its size. If you focus on the quality and strategy behind the number, it should also keep you from growing it past the point of efficiency (i.e. diminishing returns). Hopefully, this helps put some context around how I approach net worth.



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