How Concerned Are You About Net Worth?
By Yolander Prinzel
One of the first things many people do when creating their own financial plan is to determine their net worth. By adding all assets and subtracting all liabilities they will create a financial starting point that indicates how healthy their situation is or isn’t. But relying too much on this number itself without properly weighing all the factors behind it is a dangerous game that could leave you feeling more secure than you actually are.
Home is Where the Asset Is
For many Americans the fattest asset they have — and the asset that makes up the bulk of their net worth — is their home. The equity in your home can often create a six figure net worth that cash-on-hand can’t compete with. But with a depressed housing market (although the May Housing report showed that the month of April had the highest housing sales we’ve seen in 5 months thanks to the homebuyer tax credits, the market is still depressed) not only are property values falling and reducing formerly comfortable net worth figures, but houses are much less liquid than they once were.
What is Liquidity?
A liquid asset is cash or something very easy to exchange for cash. All assets have a liquidity level and a few years ago real estate was fairly liquid (though real estate is never really considered a liquid asset, Americans were buying and selling houses at one point like they might buy and sell fast food). But if you look at the number of houses for sale in your town that have been on the market for 6 or more months, you can see that the once fairly liquid real estate market is no more.
Liquid assets are a fundamental part of your financial plan. You need them in order to pay for emergencies, job losses, health problems, retirement and other immediate financial concerns. If most of your assets are tied up in illiquid investments like real estate and vehicles that can vary wildly in value from day to day, then you might be holding a straw man net worth.
Fixing the Mechanics of Your Net Worth
So then what is this obsession with net worth? If the value of your assets can shift so extremely from month to month and completely skew your numbers and certain assets shift in liquidity so that they are almost useless as forms of lifestyle funding, then who cares about net worth?
While it’s not a good idea to completely eschew the value of knowing your net worth, it is a good idea to use it as a guideline to live by rather than a psychological safe point or bragging right. Instead, net worth can be used to help you get your debt to asset ratio in better form. By looking at the debt you carry versus the assets you currently have, you can see whether or not your debt is where it should be. In addition, you can see what percentage of your net worth is tied up in illiquid assets. If you are young and just starting out, it is not out of character for 75% or more of your net worth to be comprised of illiquid assets. But as you age you should work to reduce this number so that it is less than 40% by the time you are ready to retire, the same as you should adjust the asset allocation of your investment portfolio.
Photo credit: espngo
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