How do you measure wealth, in strictly financial terms?
Some people measure wealth by the amount of money that they make, in terms of salary, revenue of a business, etc. This basically amounts to a cash inflow measure of wealth: the more you make, the higher your wealth. More, people, however, take the approach of measuring wealth by how much money they have saved. Typically, one takes assets and subtracts liabilities, with the result being net worth.
Let us take two people, A and B, with these respective financial situations:
Person A:
Monthly Salary: $5,000
Assets: $350,000
Liabilities: $150,000
Person B:
Monthly Salary: $6,000
Assets: $350,000
Liabilities: $125,000
According to salary, Person B makes more and would be considered wealthier. According to net worth, Person B’s total of $225,000 (assets minus liabilities) exceeds Person A’s total of $200,000. Thus, using either measure, Person B comes out ahead as the wealthier individual.
I propose taking another look at wealth, and looking at it in terms of months of covered expenses.
By covered expenses, I’m talking about expenses for which you have the savings available to be used, if necessary. For example, if you have $4,000 of household expenses per month, and have $4,000 saved, then you have one month of covered expenses. If you have $4,000 of household expenses per month, and have $100,000 saved, then you have 25 months of covered expenses.
Taking this concept and applying it to Person A and Person B, let’s now include the additional information on monthly expenses to the data provided above:
Person A:
Monthly Salary: $5,000
Assets: $350,000
Liabilities: $150,000
Monthly Expenses: $3,000
Person B:
Monthly Salary: $6,000
Assets: $350,000
Liabilities: $125,000
Monthly Expenses: $4,000
As you can see, I kept the salaries, assets, and liabilities the same; only monthly expenses have been added. One might be tempted to first look at monthly net cash flow, to see how that looks; both parties have equal net cash flow.
But when you look at months of covered expenses, the picture looks different:
Person A:
Net Worth: $200,000
Monthly Expenses: $3,000
Months of Covered Expenses: 66.7
Person B:
Net Worth: $225,000
Monthly Expenses: $4,000
Months of Covered Expenses: 56.25
Thus, despite Person B having a higher net worth and higher salary (as shown before), it is Person A that can survive the longest on his savings.
That’s the point – given our sustainable level of expenses, how long could we survive if our income stream completely dried up?
One could always take this further, and add in any number of caveats, such as unemployment income, interest income on savings, etc. Additionally, I do find validity in the other measures, as keeping ones earning power healthy is important, and net savings is a standard way to view wealth that most of us probably use at one time or another.
That said, I think this provides an alternative, yet easy way to look at how “wealthy” one really is. Different individuals and families have different money needs, so the value to salaries and accumulated net savings is different for everyone. By leveling the playing field, basing it on how long you could survive on what you have, it’s another way to look at where you are in terms of your finances.
What do you think of this concept? Do you have any other approaches to measuring wealth in financial terms?
Love it. I have always used a related number to judge wealth (but in units from perhaps a more optimistic viewpoint). Taking the rule of thumb of a safe 4% withdraw (or maybe 3%), I calculate the amount of one’s expenses that are covered by a safe withdraw rate of savings and any other dependable passive income. So someone who spends $100K/year and has $1M in savings is 40% free. Someone who spends $32K year and has $800K in savings is 100% free and is, therefore, wealthier. There is definitely some minimum income level required for this to fairly represent wealth in the way I intend, but after this (relatively low) level is met I don’t think people are much happier with each extra absolute dollar of spending.
Strick – thanks for the comment. I like your approach as well. Its a realistic way to gauge where one is in terms of being truly able to consider themselves “free”. Excellent stuff. This is the type of thing that I find interesting – different approaches that offer futher insight into one’s financial condition, beyond the typical measures.
I have heard of Strick’s way before and the one in the post is pretty interesting too. I guess we save for the 4% withdrawal way in mind, but I had never given it a ton of thought. Very cool post.
My husband and I have a net worth around $135,000 and monthly expenses (not including what we move to savings) of about $2900…that’s about 46 months of living expenses.
After we pay off the car this December ($330 a month) that’ll even look better. I cannot wait until 2016-2017 when we pay off the house…we’ll be able to live on $1800-$1900 a month VERY happily and have a ton extra, even after all our normal savings accounts, for vacations or hobbies…woot!
BFS – that’s great about your house situation. Way to go! The peace of mind you’ll have with less liabilities in your life will be nice. Plus, i’m inferring that you’ll have a nice gap between your income level and expenses. That’s the way to do it. Thanks for sharing!
I think monthly expenses covered should be a measure of bare minimum expenses, not a normal monthly budget. For instance, perhaps person B spends $4,000 a month, but if they lost their job, they would cut all spending but mortgage, utilities, food and gas. Then, their number of months of covered expenses may look quite similar to person A.
I think that these scenarios show how important passive income can be. (I am assuming the income noted in the post is ‘work’, not dividends, rental property, pensions, etc.) If you have a lot in savings/assets and that money is also working for you, then you are doing good!
I’m really glad I found this blog. This is exactly how I’ve always determined my level of comfort. I’ve never been willing to have less than 6 months of covered expenses. When I was a poor 22-year-old intern, I set my expenses at about $1000 a month, had take-home pay of $1200 month, and freelanced to make extra cash. Added to about $5000 I’d saved through part-time work in college, I was there within a few months. When I decided to go full-time freelance, I wanted to have a year’s cushion. And I got it within a few months through a lot of extra work. Once I had a year, I decided I could quit my part-time job and just write full-time. I kept working to get extra projects, though, and pretty soon I had several years in the bank. I was being stupid in other ways (notice I said “bank” not “investment account” — a situation I eventually rectified) but I still don’t understand how people can sleep at night with less than a few months in the bank. I know it happens in dire circumstances. But as a normal course of events? To me financial freedom means not *having* to do anything. Having as many months of covered expenses as possible, and better yet, assets generating income so you have infinite months of covered expenses, is the best way to get there.
Great idea and point! This the only way I value wealth. I recently watched the documentary “Broke” by Billy Corben on ESPN’s 30 for 30. Perhaps professional athletes should read this blog post. They could definitely learn about money management.
Whoa, does the stock market always go up ? Yuck it up future welfare recipients !!!!