Net Worth is a Lying Metric
Recently for my financial education my Dom friend directed my attention to a documentary titled "The Queen of Versailles." It's about a high net worth family riding the emotional peaks of highly leveraged real estate investments right before the 2008 crash hits. They serve as exemplars of why my Dom friend says "Cash is king." Despite being valued as billionaires by their net worth, they nearly went bankrupt as their income dried up whilst their debts kept demanding cash by the bucket-full.
High leverage finances are a wheel just waiting for the right time to strap you in and break you. When times are good, money spates like an overfull river. You're tempted to take on debt up to your capacity, and trust that your income will grow with time. Yet good times invariably regress to the mean and become average or worse times. When they do, they leave behind a pile of debt that outsizes the remaining income. Bankruptcy or foreclosure then ensue.
I refuse to use net worth as a measure for my finances. There are several contributing problems with net worth as a metric. Though given the introduction above, it should come as no surprise that the prime culprit is real estate holdings. Let's see why:
- They are some of the largest single purchases in most people's lives, and therefore represent a large portion of your net worth
- Your personal residences don't normally produce income
- What income houses do provide tends to be poor for their volatility and risk (i.e. 50% of what you charge for rent is actualised)
- Houses wear down and depreciate, contrary to most people's expectations
- It's normal to take 9:1 or 4:1 leverage (10-20% downpayment) on a mortgage
- House value is unusable until you sell it (with the caveat about HELOC)
- Its value is also highly speculative, and will crash during downturns when you need to sell it
In particular it might surprise you that houses depreciate, given that it's standard practise to "invest" in a home then trade up after a couple years of appreciation. There are multiple competing factors: the land value appreciates as the location grows more desirable, the house bleeds some value by way of living in it, but tax depreciation offsets some and renovations slip in fresh value at the cost of supplies and work. Between all the factors there's usually a net growth, but it is best to not forget where the value truly lies. The structure itself is consumed over time.
Besides renting out a property, there is another method of extracting cash from real estate: HELOC, or Home Equity Line of Credit. This comes with the same caveat that affects all credit lines: during recessions credit can dry up as banks change the terms, disable draw downs, or even recall the HELOC/close the credit.
Another frequent contributor to net worth is stocks, and unrealised gains are the muddying factor there. These show up in net worth, but they can appear or disappear overnight thanks to market conditions. Stocks are also notorious for being slightly illiquid--though not as much as houses. When the market turns down and you need cash on hand to pay bills, selling stocks at their low value is contrary to the classic advice "Buy low, sell high." As a result your once-voluminous portfolio becomes a painfully pinched pocketbook during a recession.
Whilst an inflated net worth can stoke your sense of safety, it's a poor indicator for financial health because of the aforementioned shrinkage during recessions. Net worth paints the picture only in broad terms, e.g. whether you are in debt, loaded with assets, or drifting without either. Trying to get finer granularity details out of the broad strokes of net worth is fated for failure.
I find it practical to ignore net worth during financial planning, and to instead focus on our cash runway, our current ratio, and our savings rate. They're less likely to lead me astray from my duty.