… And You should too.
Ask a wealthy person how much he is worth and typically he will have a much better idea of his net worth than the average middle class person. Why is that? Especially since it is much more difficult for a wealthy person to track.
The answer is simple, tracking your personal wealth level is an important exercise to keep you on course in building your wealth. The average middle class person is so focused on their income and expenses that they forget the big picture. For instance how are you coming on preparing for future events like retirement, children’s education, health insurance, long term care, etc.
A good exercise is to calculate your net worth at least annually. Net worth is calculated simply by taking all of your assets and subtracting your liabilities. So if you add up the value of your house and car and bank accounts and furniture etc. and then subtract how much you owe for your mortgage, car loans, credit cards etc. You will have your net worth. (If you owe more than you have you are in trouble). But you need to look at even more than that.
To the wealthy (or even “comfortable”) Net Worth is actually more important than income and for good reason. Income doesn’t mean a thing if your expenses are greater than your income. To the truly wealthy much of their income (or perhaps all of their income) is “passive income” meaning that they do not have to exchange hours for dollars. This might be in the form of investment income from “stocks and bonds” or perhaps income from real estate or even a Laundromat or car wash. That income might even change from week to week or month to month. So the idea of “income” is a bit fuzzier for them than for an individual who gets the same paycheck every week.
But income is not all of the equation. Perhaps you have heard of high earning individuals like basketball stars or commodities traders who earn millions but are actually spending more each year than they earn. They have to continue working to maintain their lifestyle. So just because they are earning a million dollars a year, if they are spending every cent of it, they aren’t getting ahead. And often they are actually getting behind faster than someone with a much smaller paycheck.
An Aha Moment
One day several years ago I got one of those “Aha Moments” reading Rich Dad Poor Dad
by Robert T. Kiyosaki (a great book by the way). For years I was always looking for ways to increase my income (or decrease my expenses) like most average middle class people. But after a while it became obvious that you can not increase your earned income indefinitely.
There are only two ways to increase your earned income.
The first way to increase your income is to earn more per hour. It wasn’t that difficult for me to go from earning minimum wage to say $10 or $20 per hour. Perhaps, you can even increase it to $40 per hour or $100 per hour. But beyond that it gets more difficult.
The only other way to increase your earned income is to work more hours. But who wants to do that? And at some point you simply don’t have any more hours to work and you can‘t earn any more per hour. So you are stuck!
So the key is to exchange your earned income for passive income.
The one way that most middle class people think of creating passive income is by saving and investing. So they can get interest and dividends. And that is certainly the first step. But that is not the only way or even the best way. Income producing Real Estate is another way that has proved successful for hundreds of years because it allows for leverage (i.e. you can borrow most of the investment) and multiply your earnings faster. But there are other ways… businesses, intellectual property, the Internet, etc.
A good example of passive income is an author who writes a book once and then gets paid hundreds or even thousands of times for the same amount of work. Song writers do the same thing… even basketball players do it by licensing the use of their name. The key is to find things that you can do once and get paid over and over for it.
Tracking Your Net Worth can Eliminate the need for a Budget
The key to wealth building is to track your progress. Once you know where you are it is easier to get where you are going. The only way to know where you are is to calculate your Net Worth… at the very least annually. Some people sit down once a year perhaps in December or January and calculate their net worth and then compare that to the previous year.
And that is a very good start. Perhaps even better is to sit down at the beginning of every quarter and calculate it. A couple of years ago I started calculating my net worth on an annual basis. And then I went to quarterly because it is very difficult to get a good handle on your finances if you don’t know where you actually stand. And how can you make changes if your data is a whole year old?
Finally, I started tracking it on a monthly basis (although occasionally I miss a month) and I found that rather than trying to keep a budget (which I always hated) it is much easier to track your net worth. If your net worth is increasing you know you are spending less than your income. But… if your net worth is decreasing you are in trouble and you need to cut back on expenses. And Net Worth is much easier to track.
Which would you rather track? Hundreds of items that you purchased every month, food, clothing, gas, utilities, mortgage etc. Or simply add up your assets like the balances in your bank account, brokerage account, insurance policies, etc. and subtract your credit card debt and mortgage etc. Perhaps only five or ten items will give you the whole picture (and you can find most of these items by looking at your monthly statements or looking them up online) .
I created a spreadsheet with my assets in one column and my liabilities in another. The columns automatically add up the total and subtract the liabilities from the assets. Every month I copy the sheet to a new monthly sheet and change the numbers to reflect the new balances in each account. And in about 20 minutes a month I can tell exactly where I stand. It works great.
Once you know your net worth, you need to know how that relates to your long term goals.
How many months Rich are you?
R. Buckminster Fuller, “Bucky” to his friends was a brilliant thinker, he might be considered the “Da Vinci” of the modern age. He invented the geodesic dome and developed a great variety of other interesting lines of thought. One was a different way to measure wealth.
He said, to imagine that you stopped working. How long could you live your current lifestyle? The key to Bucky’s system is to calculate your net worth excluding the value of your house (since you can’t spend it) without changing your lifestyle.
For example, assume you are currently spending $5,000 a month and have a net worth (not counting your house) of $100,000. By Bucky’s definition, you would be 20-months rich ($100,000 divided by $5,000).
Many individuals who thought they were rich because they have a high income, might find that they are less than one month rich. A very poor state of affairs. Others with a more moderate income but lower expenses might find that they are better off than they thought.
Retirement Planning
The next key is to determine your life expectancy and see how many more years you have to provide for.
If you are 50 years old and expect to live another 40 years (not unreasonable with today’s life extending technology). You still have a bit of preparation to go if you have only provided for 20 months.
In actuality, if you are 50 years old and expect to live another 40 years you would need enough money to finance another 480 months. At $5,000 a month you would need $2.4 Million to be considered independently wealthy (i.e. have enough wealth to cover all your expenses for the rest of your life without any additional income).
But that isn’t taking into consideration other sources of income. If you have a passive income of $5000 per month you would also be covered. Or if you had Social Security income of say $2000 per month plus investment income of $3000 per month you would also be covered.
The place to start is by calculating your net worth and then begin tracking it regularly. And then calculate how many months rich you are.
Good Luck! Now you know what the Rich know… that Net Worth and Passive income are more important than how much you earn from a job and you can really prepare for Retirement properly.
If you would like a blank copy of the spreadsheet that I use you can Download it HERE.
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