Five Cent Nickel's recent post shows that he and the rest of the buck-o-sphere (personal finance blogging) are still crackling over net worth and practical wealth so here is further elaboration of my thinking:
How To Track Your Financial Independence and Security
The first step is to choose your lifestyle (do not let a lifestyle choose you--take control of your life). The best financial measure depends upon your exact purpose. If you are planning to sell your million-dollar mansion and move into a $100k condo, then you want to track both those prices. Even so, it might be more prudent not to count the difference as wealth until the money is in your bank account. If, however, you plan to stay at your current consumption level without wrenching changes (e.g. you will stay in the same place or a similar-value residence for the rest of your life), then ignore your home value, ignore your treasured collection of collectible Star Wars action figures, and ignore anything else that you would not cash-out.
Measures to ignore:
- Net worth
- Income (general): Any income recommendation such as “80% of pre-retirement income” is nearly worthless because it ignores expenses (costs/outgo)—and expenses are the whole reason that you need income.
- Gross Income: Guidelines about what percentage of gross income to spend on Item X are nearly worthless because (1) taxes and deductions vary widely so net income varies widely, and (2) the value of “$100” of Item X can vary greatly by how much is asset value versus interest or related fees.
- Net income: Even “25% of net income” for Item X can mean very different things to different people depending upon other regular bills (medical costs, etc.). Further, income can vary and future income is less certain than past income (savings are your residual past incomes).
What to measure:
Financial security = liquid wealth divided by total expenses
e.g., divide by monthly expenses to see how many months you can go without income.
Remember to amortize infrequent expenditures (automobile purchase) into a monthly budget.
Expenditures are key
The critical value is your minimum necessary expenses, relative to available wealth (i.e. savings, not income). In other words, compare past surplus income to future costs; past income v. future outgo. You want to maximize your past, surplus, accessible income (savings/liquid wealth) and minimize your expenses.