How to calculate your real net worth

In the second of a series of articles for interactive investor, former lawyer and City money man Peter Alcaraz tells us why the sooner you know your net worth, the better.

Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters. His first book, The Wealth Game - an ordinary person's companion was published in 2016 and has become a staple amongst wealth managers, business schools and private individuals wishing to develop their personal finance skills. 

To reach O in the wealth game is to win the game. You can live the life you want without needing to work for money again. There's a lot to this so for now let's just focus on what to measure.

The wealth game balances two numbers, net worth and needs, each made up of many other numbers.

Net Worth

This is a measurement of your wealth at a point in time. You have a net worth right now, and the sooner you know it, the better. Whether positive or negative, large or small, solid or uncertain, it is your starting point. Every player should know his or her approximate net worth and be no more than an hour away from calculating a reasonably accurate figure.

The definition of your net worth is the total value of all your cash and assets, less any debt or other obligations for which you are liable. Other commonly used terms are net assets or balance sheet. They all mean the same.

Assets can split into two categories: real and financial. Real assets are property and other physical assets, and financial assets refer to money in its various forms, securities, and receivables. Debts are obligations to repay loans in all their forms: term loans, mortgages, overdrafts, IOUs, credit, hire purchase, finance leases, and so on. Other liabilities refer to any other sums due.

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Why is net worth so important?

Net worth is the little porridge pot, the well or font of wealth that delivers the cash we so desperately need to live. Without wealth you rely on earnings from work or hand-outs. Your net worth can supplement this. One day, you won’t work.

A new approach to assets

You might think that real and financial assets are self-evident, and on one level, they are. A starting definition of an asset is something that has positive, realizable monetary value. In other words, it can be exchanged or sold for a positive cash sum after selling costs. Such items should be fairly easy to spot.

But in the wealth game, what matters is whether your asset is trending up or down in value. No assets, including cash, stay the same value for long. Some inexorably appreciate over time, others waste away to nothing, and some bounce around without any clear sense of direction. Many are consumed and disappear immediately. An asset may have a positive value one day and a negative one the next. It may even become a liability if the costs of keeping and maintaining it outweigh the benefits.

From the outset, it’s important to realize that everything tangible we call an "asset" falls into one of three baskets. You should learn and understand the names and characteristics of each, as they all directly affect your wealth, either for good or bad. I have never seen them labelled in this way, but more than thirty years of personal practice bears them out. Every time you see an asset from now on, ask yourself, "Is it this type or that type?"

Appreciator

This is an asset whose value can be expected to increase over time, despite short-term fluctuations. The time frame we are concerned with is how long we plan to hold the asset. Will its value increase over the period you plan to hold it for? If the answer is yes, it is an appreciator. You need to understand its value and the drivers for it in order to have a reasonable basis for believing this. Some of this is intuitive or common sense, but more important are acquired knowledge and experience.

There are two types of appreciators: one that, as well as appreciating in value, produces an income or is capable of doing so is called a productive appreciator, and one that does not is called an unproductive appreciator. Examples of a productive appreciator might be residential property that can be rented out or company shares that pay a dividend. Unproductive appreciators include precious commodities, such as metals, jewels, art, or antiques.

You might ask whether a business is an appreciator. The answer depends on whether it is likely to prosper. If it is run badly and losing money or its products or services are falling out of favour with customers, it is unlikely to appreciate.

Appreciators are the bases for building wealth. Your job as a player in the wealth game is to find, acquire, and, if you are able, build them.

Depreciator

These wasting assets have a value that inexorably declines, possibly to nothing or to a negative value. Their value literally wastes away, perhaps because they wear out or become obsolete.

Again, the concept of productivity applies, as even a wasting asset may generate income during its life. A car, boat, caravan, bicycle, television, or computer may be rented out to others for money and become a productive depreciator. If used as a private asset, it is an unproductive depreciator. Cash is a productive depreciator, because although inflation erodes its value over time, it can earn interest if deposited with a bank or other borrower.

Even though you include depreciators in your personal balance sheet, every penny you spend on them erodes your net worth over time. Cars are classic culprits.

Consumable

A consumable is literally that-an asset that doesn't survive long enough to merit inclusion in your balance sheet. It is destined for near-term consumption and has no realistic resale value in the meantime. For example, if I spend two pounds on ice cream and then eat it, for a moment after purchase, I hold an asset possibly equal in value to the money I have spent.

Once eaten, I'm down two pounds and up a few ounces in weight. A poor deal were it not for the pleasure hit. All food and drink are consumables, as is fuel in the car. I also include all personal effects, like clothes, shoes, books, CDs, DVDs, toys, leisure and hobby items, and so on.

Do not include consumables in your net worth calculation. They have no meaningful value and don't produce income.

Needs

Needs make up the liability side of the equation. They erode your net worth, so every pound reduction in your needs adds to your net worth. Think about this for a minute.

A need is something that you must have in order to function and live. You can’t survive without it. A want, on the other hand, is something you'd like but isn’t absolutely necessary. Economists often assume that our wants are limitless. In reality, what you want is a personal
choice.

Your task in the game is to identify your needs and decide on a range of wants that satisfy you but allow you to reach O as quickly as possible. Only include those that cost money, and ignore all others, even if they take up time in which you could be earning. Too expensive a package will hold you back for years and may halt your progress.

Design your own package

Here, you become the architect of your needs instead of letting others define them.

Lifestyle is sold to us by those who wish to profit. Businesses want our money; media want our attention; government wants our vote and our cash, through taxes; and religious institutions want our patronage. We are the prize at the centre of a gigantic bun-fight between contenders rooted in self-interest and a powerful will to survive. Our collective behaviours determine whether they live or die, and they fight hard to influence us.

These peddlers and purveyors try to define and meet our needs. Like a vast auto-enrolling outsourcing machine, they can take over this department of our lives and run it for us: what to wear, eat, drink, read, watch, listen to, learn, drive, believe, think, and care about; where to live, work, holiday, invest our money; how to be healthy and safe; and who to respect, disrespect, value, emulate, like, dislike, love, hate, reward, and pity.

From the industry corner, here are some examples of the guidance directing us to never knowingly underspend:

"Because you're worth it" - You deserve it and owe it to yourself. It's your right to buy this treat. Don't compromise. After all, you are precious and valuable, rare and unique.  You've worked hard. It's just a little something to reward yourself. What harm could there be in that? In fact, what reasonable and loving person in their right mind would deny you that small pleasure?

"Because your husband or wife is worth it" - For all his or her unstinting efforts, the
hardships he or she puts up with, and the sacrifices he or she makes for the good of the relationship and family, it's the least you can do. Build that pedestal high, and polish it.

"Because your children are worth it"- After all, they are the most beautiful, wonderful offspring on the planet, are young for such a short time, and deserve your generosity before facing the hard world out there. The best parties, party bags, Christmas and birthday presents, foreign holidays, clothes, games, and gadgets are surely not too much to ask.

"Retail therapy" - Yes, it is actually good for you, physically and mentally, to go out or online and buy things. It's stimulating and fun and takes your mind off difficulties and worries.

"Live the dream" - No matter that the last one never quite lived up to the brochure; this time it'll be different, and your dreams will become reality with this simple purchase.

"Life's too short; live for today" or "YOLO: you only live once" - Spend it while you can, because you may not be around tomorrow, and if you are, tough luck, because the money will have run out.

"You can't take it with you when you go" - On that basis, why bother about anything?

"Cash rich, time poor" - You'd better spend your money to equalize matters.

"The latest version" - It's better than before. It’s smarter and more functional and will please you more. Who wants to be seen with an old version?

"Petrol head" - Wear this badge of honour proudly, drive fast and large, and look down on all beneath or behind.

"It's sale time" - Buy three for the price of two, even though you only want one. Spend to save, and grab a bargain.

"Only the best/you get what you pay for" - Under this snob's charter, it really is better quality, even if you wouldn't know it on a blind test.

"Brands are best" - Pay a lot of money for our product, and then advertise it for us by wearing the label on the outside. It’s really cool and just proves your good taste and affluence.

"Dress to impress"- As a "manic impressive," - you will garner more lovers, better jobs, and greater status, and people really will like you more.

"Learn to be a collector" - Become a "connoisseur," an expert in your field, and an authority on the subject, and perfect the art of buying.

"Out with the old; in with the new" - Spring-clean your life, make a new beginning, and start all over again with some new purchases, this time getting it right.

"Don't let the side down" - Avoid the humiliation and embarrassment of being the shabbiest on the street, being the tattiest at the school gate, or having dull "staycations." Think of your family, neighbours, and friends. And worst of all, don't let yourself down with poor standards. Where’s your self-respect?

"You can afford it" - Of all people, you shouldn't be holding back!

"Do your bit to help the economy" - Everyone knows that recessions are caused, or at least prolonged, by demand drying up. Spend, spend, and spend some more to do your bit to lift us all out of this mess.

"Fair trade" - Help poor people by buying this product.

Opting out of being led to spend in the wealth game is surprisingly easy, as long as you can disconnect. Choose what to listen to and when, and to those who do manage to reach you, just listen politely and say no thank you. Design your own lifestyle and needs from scratch instead of using default options. The information, transparency, and connectedness delivered by the internet make it a buyers' market. You design, specify, research, select, and purchase on your own terms.

A tendency towards wilful and independent thought and a certain two-fingers-up attitude to what others think is essential. Instead of "because I'm worth it," try "because I'm worth more." And as for "live for today, not tomorrow," how about "live today and provide for tomorrow"? The joy of slogans is that they are so versatile.

How can you quantify your needs? Read next week to find out…

Peter Alcaraz is a freelance contributor and not a direct employee of interactive investor.