A Tricky Net Worth Problem; Who Is The Richest Of Them All?

by golbguru on February 28, 2007

Everyone wants to be *rich*, right? (duh). Almost everyone who wants to be rich would be tracking his/her net worth very closely through some kind of a balance sheet. But sometimes, I wonder if most of us really understand what *rich* (or wealthy) means in terms of our assets, liabilities, and net worth. Here are a few example questions that can quickly cause confusion in this respect:

  • If you compare your net worth now to your net worth 5 years ago, how would you know if you are wealthier now than in the past?
  • Are two people with the same net worth equally rich?
  • Between two people, is the one with greater net worth wealthier than the other?
  • Are people with more income wealthier than people with less income?

The questions look trivial don’t they? :) Instinctively, most of us (including me) would start looking at the net worth numbers on a balance sheet to and attempt some kind of a comparison. The problem with this approach is that raw net worth numbers can totally throw you off the track.

Some bloggers (like Flexo and Ben) have discussed the importance of ratios (as opposed to raw net worth) in evaluating your financial situation, but may be, even these are not enough to determine whether you are wealthy (for reasons that will be clear with the examples). I will consider two popular ratios for this post:

  • The debt/income ratio: Lower is better; lowest possible value is zero.
  • The assets/debt ratio: Higher is better; highest possible value is infinity.

Here is another method (rule of thumb) proposed in “The Millionaire Next Door” by Stanley and Danko to find out whether you are wealthy or not (let’s call this Stanley and Danko rule):

Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.

Now, lets assume that there are 5 friends (say V, W, X, Y, and Z) all 30 years old. Your task is to compare their balance sheets and determine the richest of them all. Their income, debt, net worth, and assets are shown graphically below. For each of them, the two popular ratios mentioned above and their classification according to Stanley and Danko are given along with the graph (if you apply the Stanley and Danko rule to them, at their present age, they would be categorized as “wealthy” if their net worth is equal to or more than three times their income). Your job is simple, just look at them and help me locate the *richest*. I will make it even simpler for you by making their net worths the same (all of them have a net worth of $60,000).

Mr. V’s info: Debt/Income ratio = 0; Asset/Debt ratio = infinity. Stanley and Danko rule says - wealthy

zero debt interesting-numbers

Mr. W’s info: Debt/Income ratio = 1.5; Asset/Debt ratio = 3. Stanley and Danko rule says - wealthy

debt greater than income interesting-numbers

Mr. X’s info: Debt/Income ratio = 0.6; Asset/Debt ratio = 3. Stanley and Danko rule says - not wealthy

debt lesser than income interesting-numbers

Mr. Y’s info: Debt/Income ratio = 1.2; Asset/Debt ratio = 2. Stanley and Danko rule says - not wealthy

debt much more than income

Mr. Z’s info: Debt/Income ratio = 1.33; Asset/Debt ratio = 1.75. Stanley and Danko rule says - not wealthy

debt much much more than income

So go crazy with all the ratios you want and drop a line with your answer as to who is the wealthiest among the 5 guys. :)
I have deliberately not specified the purpose of this post; by the time you work out on who is rich, you will figure that out yourself. :) I think this might be a learning moment for some of us and the assumptions that we make about our and other people’s net worth.

If you extend your results to future years, who, do you think, will be the richest in the long run?

Also, if you were to ignore the ratios completely and just go with a gut feeling…who one would you point out as the richest?

Related Articles:

{ 4 trackbacks }

The Simple Dollar » The Simple Dollar Morning Roundup: Hurley Can’t Drive A Clutch Edition
03.01.07 at 5:30 am
Mapgirl’s Fiscal Challenge / Carnival of Personal Finance #90!
03.05.07 at 5:31 am
The Simple Dollar » The Simple Dollar Morning Roundup: French Fries Edition
03.23.07 at 5:30 am
Carnival Of Personal Finance #99 - Awesome Money Quotes Edition
05.07.07 at 4:09 am

{ 14 comments… read them below or add one }

1 Sun 02.28.07 at 10:19 am

It looks to me the first two are in better shape then the others. And no. 3 can also be considered as wealthy, in my opinion.

2 moom 02.28.07 at 10:33 am

I can’t see any of the images that you posted on your site for some reason.

3 saving advice 03.01.07 at 5:51 am

Interesting post…need to get a few more cups of coffee in me before I look at these a bit closer ;)

4 The Digerati Life 03.01.07 at 9:37 am

wow, I guess I’m not in as good a shape as I thought I was! I simply figured that net worth = assets - liabilities would measure my financial standing but no….! In the case of income alone, I wouldn’t be faring as well especially in the West Coast. This post opened my eyes and I thought I’ve covered all there was to cover with net worth. I better read up more on Flexo’s, Ben’s, JLP’s, and other folks’ ratio discussions out there. Great post Golb!

5 Gaming the Credit System 03.01.07 at 11:14 am

It’s an interesting exercise, but something that struck me about the formula from MND is that it gets less and less reasonable the younger you are. For example, if you’re 24 years old, just out of school, and have a new job at $80k, your net worth should be $192k, which simply isn’t reasonable. Similarly, according to the formula, my net worth “should be” more than the sum of all of my pre-tax earnings, ever (I’m 26 years old).

So this formula gets rapidly more absurd as you get younger. IMO 30 years old is still too young for this formula to apply. Also, (this is a related problem) this formula becomes very wrong if you have a huge change in your income recently. If you go from making $50k to $100k in one year, then your newly-calculated wealth status will be horribly skewed by your current income, which is not representative of your earlier income.

So I would say that you should only take this formula seriously only if 1) You are over 45; or 2) You have had at least a 10-year period of relatively stable (or declining) income with no huge upward leaps. I believe that the authors of MND would not disagree with me on this. Most of the “Millionaires next door” that they profiled in the book were older (50’s or 60’s) with grown children, established businesses, etc. I can’t recall a profile of a single thirty-something in the book that wasn’t an example of a child on Economic Outpatient Care.

6 golbguru 03.01.07 at 11:48 am

Sun: There may be more to it, but I haven’t been able to point out exactly what those factors are…the first one sounds “financially conservative” to me and probably may not be the richest of the lot in the long run…I need to look into it more.

saving advice: just a reminder to look into this again, assuming you had your coffee. :)

SVB: Hmm..I am not in a good shape either when it comes to comparing such data..but I am in the process of reading more. In fact, I just started reading about it, and this is the first question that came to me…so I just emptied my mind out on this post.

Gaming the Credit System: I think you are getting the point. :) Finding whether you are wealthy is not as easy as it appears to be at first glance. Ratios and rules-of-thumb (like those in The Millionaire Next Door) are just *pointers* towards your financial situation. I have attempted to show the apparent conflict between the ratios and the MND formula with the post. Most formulas will not take abrupt changes in data like you mentioned. Just goes towards saying that one should be careful with respect to conclusions drawn using standard formulas.

7 BD 03.01.07 at 11:58 am

Like Moom, I cannot see any of the images you used on this post! I use IE 6 on a Windows machine.

8 Golbguru 03.01.07 at 12:10 pm

BD (and others who are having the same problem): I am trying to find more information on this (for Safari and IE 6) but so far not much success.

I checked IE 7 and Firefox 2.0.0.2 and it shows up ok.

Currently the images are in GIF format (256 colors). I will save them as JPG and upload them again. Sorry for the trouble.

9 Debbie 03.01.07 at 1:49 pm

They all look equally rich to me–if one died and the will said I got everything, the assets would be used to pay the debts and then I would get the remaining $60,000.

However, by tomorrow, that would be different, assuming that the assets have lower growth rates than the debt interest rates. Then the people with lower debts would be richer.

Also, I feel a person who can acquire $60,000 on an income of $20,000 may also be richer in the future than a person who needed a $50,000 income to do that. On the other hand, if one of these people just got out of law or medical school and just started earning this money, they look on the road becoming richer more quickly.

By the way, the formula is also no good for your later years in life–it’s best in your middle years. I think it’s a way at getting at the idea that people who are used to living with a lower income may not need as much money to feel comfortable than those used to having a higher income–maybe they live somewhere cheaper or have less expensive tastes. Also, if you haven’t been making much money, you can’t save much, but looking at percentages lets you compare yourself to others.

10 Super Saver 03.01.07 at 8:00 pm

Golbguru,

To me the Stanley and Danko rule describes whether one is “doing well financally,” or “well off.” I would say none of the examples above depict what I would call “wealthy.”

11 BD 03.02.07 at 9:43 am

Thanks! I can see the graphs now, just not the smiley face icon. Also, I read your feed through bloglines (in IE 6) and the images don’t usually show up there either.

12 golbguru 03.02.07 at 5:51 pm

Debbie: You could pay off the debts provided there is enough solvency in their assets :)

You are on the money when you say “assuming that the assets have lower growth rates than the debt interest rates”…It brings out an important point in net worth figures. These are *static* calculations and do not include historical data or attempt any prediction. So unless we have net worth data from the last few years (at least enough for a fair average), all our attempts are determining the *rich* are valid only for the point of time in which the data was generated.

As for the question of whose net worth is healthier (or who will be richer in future)…it’s again very vague as you correctly point it out. We need to analyze a lot of supplemental historical data (like what’s the rate of return on investments, what’s the debt rate, and so on) to really put our finger on who will be richer.

I played with some percentages, but that area is also a bit tricky…for example, a person with $1000 in hand is wealthier than a person with $1 in hand (assuming all other aspects : income, debt, other assets are zero). If you give $1 to both of them, the wealth of the $1 guy increases by 100%, while the wealth of the $1000 guy increases only by 0.1% though the absolute increase in wealth for both of them was the same.

Sorry, I am wandering a bit here about what I set show..but I guess all this goes to show that it’s not as easy as “my net worth is more than the other guy so I am better off” :)

Super Saver: Yeah, I agree with you on your interpretation of Stanley and Danko rule…as long as people use it under reasonable situations.

13 Miguel 03.05.07 at 7:44 am

I have some problems with the Stanley/Danko rule. For one thing, many relatively wealthy people do not rely on regular incomes - it is largely based on business income or bonus income, and so it can vary greatly from year to year. So, the ratios can be very distorted. If I made $100,0000 this year, but only stand to make say $50,000 next year, then how should I use the ratios?

Bottom-line is that wealth is not easy to compare, not in dollar terms and not in ratios either. I think of wealth as the ability to fund future expenses. When I reach a point where my future expenses can be passively funded in thru my life expectancy, then I’ll regard myself as wealthy.

14 karla (threadbndr) 03.14.07 at 1:29 pm

When I look at my net worth, I try hard not to compare myself to others (networthIQ notwithstanding). I chart mine every quarter. Am I trending up? Can I explain the downtrend times? ( IE - market movements are ok, overspending the budget and taking funds from saving is NOT!) Is my debt to income ratio falling? Is my saving to income ratio rising?

How are my various types of assets performing? Do I need to rebalance? Have I looked at tax implications? Are my goals and budget still appropriate? Take care of the small stuff and the big stuff will fall into line.

Leave a Comment

You can use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>