Measuring Wealth, a Target for Financial Practice

If we are to have a financial practice, we need to know what we are aiming at. We need to know, “How much is enough?” The best exposition on this topic that I’ve read is in the book, The Millionaire Next Door, by Thomas Stanley and William Danko.
When someone says that another person is rich or wealthy, they typically mean that person has a relatively high gross income relative to other people. We’ve seen that in the fiscal cliff debates, where congress and the president have argued over where to draw the line between the “rich” and everyone else in terms of gross income.
But gross income is just the sum of all sources of income, earned and unearned, that a person has received in the course of a year. It says nothing about what she has spent, what she has saved, or what she has accumulated over the course of her life.
A better measure for determining wealth is net worth. Net worth is just the difference between the sum of all your assets (everything you own), and the sum of all your liabilities (everything you owe). Net worth measures what’s left after all the dust has settled; it measures what you have to show for all your work.
But net worth by itself is not enough to measure wealth. Say Joe (age 40) makes a million dollars a year, but only has a net worth of a hundred thousand dollars. If Joe lost that income tomorrow, he could only sustain his current lifestyle for less than six weeks. But if John (age 50), who makes a hundred thousand a year and has a net worth of one million, lost his job tomorrow, he could sustain his lifestyle for ten years.
For Stanley and Danko, a person has “enough” when her net worth is at least equal to her age times her gross income less inherited wealth, divided by 10. Using this model for wealth, John has twice more than “enough”, but Joe has only about 3% of what would be enough for him by age 50. So even though Joe makes ten times more than John, John is in fact in much better financial shape than Joe. John is “wealthier.”
Hence the target I use to determine whether we have “enough” is the sum of our age times gross incomes divided by 10, and compare our net worth to that number.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s