Net worth is useful to see where your money has gone, but it sucks for working out financial independence targets. Here’s an argument for income versus expenditure instead.
Bit whiney for you, SierraWhiskyMike… what’s wrong? Do you need a hug?
So this post came to mind after reading a few Reddit posts and doing my own net worth assessment with my partner.
The problem is that on paper both the Redditors and my partner and I had made loads of progress towards financial independence. We had emergency savings, investments growing (hooray! – but that also means any investments we make now cost more. Boo!) and our net worth was looking healthy. All good stuff.
Except that none of us were much closer to financial freedom. In the case of my partner and I, our net worth has doubled in a few short years: we reckon we could sell off our assets, liquidate down to net worth, and disappear for 2 years without any serious repercussions at our current rate of spend. A cause for celebration, no?
Not as much as you’d think.
When we dug into the numbers, we suddenly realised that these paper gains weren’t actually enough to do that. We could disappear for a year, sure; but we couldn’t have returned without completely starting over. This sabbatical looking less and less likely as we scrutinised the data, we came to a sad conclusion:
Net worth is for your ego. Cash flow is what we ought to be measuring for financial independence.
I’ll explain more… and try not to rant/ cry/ stare into the grim void of the abyss and scream.
Net worth – what it means and why it sucks
Net worth is pretty much a measure of all the cash you could have if you sold all your stuff today. Sell your house, your car, your clothes, all the random stuff in the shed, all of it. Assuming that you were happy embracing nudity and homelessness, all you’d have left would be a big pile of banknotes. Well, probably just a bank account balance of numbers, but money mountain sounds cooler.
Your Money or Your Life tells you to do a net worth audit as your first step. The idea is that by doing a full audit of everything you own, you see where your life energy (i.e. that money that you earn with your time, that life energy) is spent. You can’t manage what you don’t measure, so this helps you to realise how much wealth is currently tied up in (potentially meaningless) stuff. By seeing it, you learn to stop tying it up in meaningless stuff. For Vicki Robin and Joe Dominguez, the net worth audit shows you the evidence of how inefficiently you were using your money.
That’s a pretty cool use of net worth: working out where everything went. You can’t manage what you don’t measure, it makes sense.
Right, so net worth is good for working out what you could sell off if you really have to. Why does it suck?
Here’s the problem: net worth is a great figure for working out what you could do. If you completely upended your entire way of life and sold it all, you could go and restart with that cash. Move far away, live on the beach, get a job milking coconuts (or whatever)…
…but you’re not going to, are you?
You still need somewhere to sleep. Cash makes for a terrible tent, and electronic cash in a bank account makes an even worse shelter. So, let’s just not sell the home just yet. You might downsize, but you might not want to.
Which is a problem for our awesome net worth figure. Here’s an awesome post by Occam Investing that (fortunately for me!) ran all of the analysis on the Office of National Statistics figures already. If you have a look, you’ll see a cool pie chart that says that property wealth (generally, the family home) makes up 35% of the average Brit’s net worth.
Wow, we just wrote off 35% of that escape fund at the first hurdle! OK, fair enough, but what if we sold all our other stuff?
Well, the same data suggests that this comes to about 9% of net worth for the average Brit. Bear in mind that this is all ages. If you’re 23 and have just bought an expensive car, most of your money is probably tied up in that. Which is great, but you might decide “I need that car to go to work…”. Well – boom! There goes another bit!
What about that jewellery your gran gave you? That’s worth quite a bit of money, but can you really sell it?
I think you get my point. Net worth is cool, but focusing on net worth is just data porn. It doesn’t help you.
Exceptions that prove the rule
Now, there are some exceptions, but they prove the rule rather than disprove it.
For example: you might decide that you’re going to downsize to a smaller home, or do some awesome geo-arbitrage and sell your 3-bed in Hounslow for a 5-bed detached in Humberside. Sure, you might. Why not?
This would turn your home into an investment. I’m of the Robert Kiyosaki belief that a home isn’t usually an asset, but if you use it as an investment because you plan to downsize and release the equity then it’s definitely an asset. You bought it with the intention of it growing in capital value faster than other homes, then you sold it and bought this other home, benefitting from the faster growth in value. Well done, you’ve found an exception to the general net worth “rule” that I’ve set up. Good for you! Way to stick it to SierraWhiskyMike, he could use being taken down a notch.
However, that’s not the whole story. You still need to replace that roof over your head… and now you’re proving my net worth theory right again. You’ve freed up cash, but some of it needs to go back into meeting that need for shelter. How much exactly is up to you, but it’s undeniably a necessity.
OK, for the sake of appeasing the more argumentative readers, it is totally possible to liquidate your assets and survive off grid in a mud and sticks hut. I’ve read about it being done, it’s definitely doable. However, just because someone has done it, doesn’t imply that it is to be done.
An alternative: cash in vs. cash out
I put it to you: if you are earning enough passive income to pay your rent, your bills and your entertainment, you’re financially independent by pretty much any definition. This means that you can logically be financially independent without owning your home outright. I count capital growth that you can skim off without losing your original investment cash as income, for these purposes.
I’m not saying “don’t buy a home”. Do what’s right for you – but being financially independent doesn’t require you to have a paid-off house, just assets to live off. They could be anything.
This seems important because it takes a lot of time to raise capital to park in a building that comprises 35% of the average Brit’s net worth and yet generates no income in return. Depending on where you live, it might be the best idea ever to buy a home. Alternatively, it might just delay your financial independence.
Similarly, owning a lot of personal possessions might be a good thing – if that painting on your wall accumulates capital value and you are going to sell it. Alternatively, it might just be another thing that sucks up your money and delays financial independence.
Geoarbitrage
Geoarbitrage is a great French-sounding word for just moving somewhere cheaper so that the same level of net worth gives you more freedom. This happens because the same net worth in different places frees up more liquid assets that generates more cash flow. Obviously, to extremes, you can completely decamp to a different country and exploit the spending power of a strong pound against a weaker pesos. However, less drastically, you could downsize to a smaller home or move from an expensive postcode to a cheaper suburb to achieve a similar (but smaller) effect.
This is something that’s covered in the Tim Ferriss book The Four-Hour Work Week. I’ve been doing quite a few book reviews, so this post is a bit of a break, but I promise I’ll post a review at some point. You can buy the book through this affiliate link and Jeff B will grace me with some pennies, but you could probably also get your library to buy it:
The fact that geoarbitrage exists is proof that net worth is pure ego-stroking. Logically, if the same net worth in the UK buys you financial freedom somewhere else, then net worth can’t be a measure of financial independence. The numbers are a lie!
Ugh! Fine, you’ve made your point! So what? How is this useful?
Maybe I’ve just completely poo-pooed your idea and you’re reading this with absolute outrage and disgust. “How dare he challenge my belief that owning an eight-bedroom mega-mansion in Twickenham (?) is the very definition of financial success! Scandalous, I’ll take to Twitter!”.
For those of you with a more iron constitution: my point is simply that focusing on net worth isn’t helpful as a measure of progress. It doesn’t represent freedom, which is what this financial independence campaign is all about.
Instead, I suggest that the focus of success should be:
“If I ran off the 4% rule, how many years could I pay my accommodation, bills and lifestyle costs, using only liquid assets?”
(I’ll include pensions in liquid assets for this purpose.)
Net worth should be irrelevant, unless you plan to extract the equity from your home by gearbitrage or downsizing or something.
How I’m applying this to my financial independence campaign
Controversially, we do overpay our mortgage. The reason for this is that we do plan to relocate and/or geoarbitrage upon reaching financial independence, and we’re getting a reasonable return from our home equity. However, I see this as a bill, rather than an investment per se – it doesn’t factor in my day-to-day calculations of progress, and if we hadn’t done our net worth assessment with a view to potential geoarbitrage in future I wouldn’t have considered it.
We’re also on the cusp of 60% Loan To Value (LTV) on our mortgage. When we hit this magic number, which is the lowest bracket for mortgage interest calculations, we intend to stop and invest the spare cash. If interest rates rise (doubtful, but you never know) we’ll be comfortable knowing that our mortgage payments shouldn’t change drastically.
It also means that, after getting rid of the car back in 2020, I have zero intention of buying another in the short term. Yes, I have no doubt that my neighbours truly believe that my net worth is lower than theirs. Whatever. As I try to invest more in appreciating or income-producing assets, I’m noticing that my passive income is starting to creep up over time, and I truly believe that at some point my cash flow plan will carry me to freedom before the commute kills me.
