The words “wealth” and “wealth management” are used frequently in advertisements for financial products (e.g., exchange-traded funds or ETFs and cryptocurrency) and financial services (e.g., specific investment advisory firms). This begs the questions “what, exactly, is wealth?” and “how do people know when they, themselves, are wealthy?”
One online dictionary defines wealth as “an abundance of valuable possessions or money.” Another states that wealth is “plentiful supplies of particular resources” and notes that wealth can be held by individuals, communities, and countries.
Other sources describe different categories of wealth including:
- Financial wealth – income and assets
- Time wealth – freedom
- Social wealth – strong relationships and social capital
- Physical wealth – good physical and mental health
The remainder of this post will focus on financial wealth, specifically three ways to measure it to provide an answer the second question, above. Specifically, three wealth-measurement metrics will be explored and explained.
Net Worth Calculation
A common way to measure wealth is with a net worth statement. Net worth is calculated by subtracting debts from assets. For example, $200,000 of assets minus $100,000 of debt equals a net worth of $100,000.
Three categories of assets are:
- Cash assets – e.g., bank accounts, money market funds, and certificates of deposit
- Investment assets – e.g., stocks, bonds, mutual funds, and ETFs
- Property assets – e.g., house, car, home furnishings, and electronics
Two categories of debt are:
- Current debts – e.g., medical bills, credit card balances, and other debts expected to be repaid within a year
- Long-term debts – e.g., car loans, student loans, and mortgages
A good financial goal is to increase net worth by at least 5% a year.
This is done through increased savings and/or reduced debt.
Use the Net Worth Calculation Spreadsheet (in Excel) or this “paper and pencil” print worksheet to keep track of your progress. Some people also set specific net worth attainment goals such as $1 million before retirement.
The “Wealth Test”
In the book The Millionaire Next Door by Thomas J. Stanley and William D. Danko, the authors outline a simple “How to Determine If You’re Wealthy” formula to determine the adequacy of a person’s net worth at any point in life. The formula works as follows: multiply your age times your realized pretax annual income from all sources, excluding inheritances, and divide it by 10.
For example, a couple, both age 50, with a combined annual income of $80,000 should have a net worth of $400,000, calculated as follows: 50 x $80,000 = $4,000,000 ÷ 10 = $400,000.
The authors state that the figure derived from the formula is what the minimum net worth should be for a particular age and income combination. The more people exceed their formula-based figure, the better.
A third metric for wealth considers, not only an individual’s or couple’s age and income, but where they live. After all, there is big difference in living costs between, say, Manhattan, Kansas and Manhattan, NYC.
The New York Times What Percent Are You? tool asks users to enter a household income. Then they click “Go” and results indicate where they place, income-wise, in percentile among U.S. residents. For example, household incomes of $30,000, $50,000, 100,000, and $200,000 are in the bottom 29%, bottom 49%, top 21%, and top 5% of incomes, respectively.
Users can also hover over the U.S. map to get household income rankings for over 300 metro areas.
Another interesting calculator is Wealthometer, where users compare their estimate of the percentage of Americans with less wealth than they have. Users enter numbers for real assets, financial assets, and debt and the number of household members. Results are presented in a bar graph showing the position of the user’s estimate of their comparative wealth with their actual position based on government wealth data.
What Not to Do
Some people judge their wealth in comparison to neighbors with expensive cars, clothes, and houses. This is a mistake. The neighbors could be in over their head in debt. As Stanley and Danko describe in their book “ Big Hat, No Cattle.”
The best way to measure financial wealth is with objective metrics and to always remember that net worth ≠ self-worth.