In personal finance, the ability to track progress over time is essential. We often hear about comparing the performance of your investment accounts to some benchmark – meaning how well your investment account has grown compared to some other portfolio of investments. There is a lot to say on the topic of benchmarks, and often, people get hung up on comparing their investments to a benchmark that has little in common with their financial plan. However, there is one critical metric that should be part of everyone’s financial plan, and that is Net Worth.
Net Worth: The Standard Metric
Net worth is a snapshot of your financial status, representing the total value of your assets minus your liabilities. It’s a simple equation: what you own minus what you owe. This includes:
Cash and Equivalents: Immediate funds in checking and savings accounts.
Investments: Holdings in stocks, bonds, ETFs, mutual funds, and other securities.
Retirement Accounts: Funds in 401(k)s, IRAs, and other retirement plans.
Real Estate: Market value of owned property.
Personal Property: Value of items like cars, jewelry, and art.
Liabilities: Debts, including mortgages, loans, credit card balances, and other financial obligations.
For many, a substantial portion of net worth is tied up in home equity. However, net worth can be misleading, including assets not readily convertible to cash. When looking into your financial wealth at a point in time, it is essential to consider the assets you have today that can pay for things, services, or experiences today.
Liquid Net Worth: A Closer Look at Financial Preparedness
Liquid net worth refines the concept by focusing on assets that can be quickly converted into cash. It’s calculated as:
Liquid net worth = Liquid assets – Debts
The composition of liquid net worth includes:
Liquid Assets: Cash, equivalents, and investments that can be quickly sold without significant loss.
Liabilities: Similar to net worth, encompassing all debts and obligations.
This metric provides a more accurate representation of your ability to handle financial emergencies and opportunities. It reflects the portion of your readily accessible wealth, unlike fixed assets like homes or retirement accounts, which are not immediately liquid.
Why Liquid Net Worth Matters
Liquid net worth is crucial for several reasons:
Emergency Preparedness: It indicates your ability to handle unexpected financial crises without incurring additional debt.
- Investment Opportunities: A higher liquid net worth means more flexibility to capitalize on timely investment opportunities.
- Financial Flexibility: It offers a realistic view of your available resources for spending, investing, or saving.
Case Study: The Tale of Two Net Worths
Imagine two individuals: Person A has a high net worth due to substantial property ownership but a low liquid net worth. Person B has a lower net worth but a higher liquid net worth due to significant holdings in liquid assets. In a financial downturn, Person B is better positioned to manage immediate expenses and take advantage of market opportunities. After all, you can’t pull a few bricks out of your house to cover your summer vacation, but you can certainly sell some shares of a diversified portfolio in your brokerage account. While there are ways to create liquidity from an illiquid asset, such as a home, these options come at a cost in the name of interest and fees. Utilizing a home equity loan or a home equity line of credit (HELOC) is a way to create liquidity from your home, but it requires you to take on a liability to do so. This is not to say that using your home’s equity as a source for specific funding is terrible, but don’t fool yourself into thinking that borrowing against your home is a “free lunch.”
The two charts below present the stark difference between net and liquid net worth by age in the United States. (Data is from the Survey of Consumer Finances, 2022)
Growing Your Liquid Net Worth
Increasing your liquid net worth boils down to either enhancing your liquid assets or reducing your liabilities. Strategies include:
- Saving and Investing Wisely: Focus on accumulating assets that can be easily liquidated.
- Debt Management: Paying off high-interest debts is crucial. There is no hard and set rule, but generally speaking, I recommend that for debts with interest rates above 8%, prioritize repayment. For those below 4%, consider maintaining minimum payments while investing in liquid assets. Debts with rates between 4%-8% take a balanced approach.
- Income Maximization: Boosting your income provides more opportunities to enhance your liquid asset base.
While liquid net worth is a vital measure, it has its limitations. It operates assuming all debts could be called in simultaneously, an unlikely scenario. Therefore, in real-life financial emergencies, the focus should be more on liquid assets than liquid net worth.
Conclusion: Balancing Net Worth and Liquid Net Worth
Net worth and liquid net worth are both important financial metrics. Net worth offers a broader view of your financial progress, while liquid net worth provides a more accurate picture of your financial agility and preparedness. In an increasingly unpredictable financial environment, having a clear understanding of both, especially your liquid net worth, can mean the difference between financial stability and distress.
As you navigate your financial journey, remember that the ultimate goal is not just to accumulate wealth but to ensure that a significant portion of it is readily accessible when you need it most. This balance is the key to not only surviving financial downturns but also thriving in them.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
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