Americans’ Net Worth in the Federal Reserve’s Survey of Consumer Finances (SCF)

What if a Quarter of Your Wealth Were Imaginary?

Net worth is a favorite topic in the buck-o-sphere (personal finance blog-o-sphere) and many people pounce on a government or media report to see how they stack up against their fellow Americans. You need to understand the source of the information and know how to read economic and financial reports correctly.

The Federal Reserve’s triennial Survey of Consumer Finances (SCF) and specifically its net worth numbers provide good examples on what to watch.

Time Lag

A report that comes out today might have no current data and instead be based on data from a few years ago. The 2003 SCF report used 1998-2001 data. The 2006 SCF report used 2001-2004 data. Most people will not see 2007 data until the 2009 SCF report.

Forgetting this point can lead to faulty decisions. One blogger recently linked to a 2003 article and compared his/her 2007 net worth to 2001 data.

Real (Inflation-Adjusted) V. Nominal Dollars

The SCF adjusts for inflation but its tables are not labeled as “real” dollars, making it too easy for the casual reader to assume nominal (un-adjusted) dollars. Further, the SCF uses a “current methods” adjusted CPI which assumes less of an inflation bite than the official CPI does.

How Do They Get People’s Financial Information?

The SCF is a survey, not a census. Like much government data, the results depend on “Gallup poll” types of problems such as sampling error, weighting, refusal to participate, and similar issues. The survey firm NORC conducts the survey of approximately 4,000 families to estimate the United States (a statistically significant sample). The accuracy of the Federal Reserve’s SCF depends upon the accuracy of Joe Sixpack’s financial self-knowledge when questioned by NORC.

Whose Net Worth?

The SCF’s “family” is technically the Primary Economic Unit (PEU) of a household. The SCF uses an unusual definition of “family” that includes single-person households. The PEU is a hybrid between other government definitions of family and households. The average US family is a bit over 3 persons and the average household is a bit under 3 persons.

“Age” is the age of “head” of “family” and the age of others in the PEU can vary from that, so 2 “40-year-old” households might have very different average ages (is the spouse 30 or 50?) and therefore have had different amounts of time to accumulate wealth.

What Counts?

The medians of many assets and debts are “conditional medians” that exclude zero to show a typical holding of a family that possesses the item in question (e.g., the median debt of debtors, not the median debt of everyone including debt-free people, which would lower the figure considerably).

The SCF counts a 401k but it ignores a defined-benefit pension (by the way, the proper absence of a defined-benefit pension from “net worth” is another reason why net worth is for measuring current wealth and is not very good at estimating future wealth). The SCF also ignores Social Security. The SCF appears to ignore tax liabilities.

Paper Profits

Net worth includes volatile asset prices (stocks, real estate) that can bubble or crash. Median unrealized capital gains ("paper profits") accounted for about 25-30% of median net worth for all but the youngest age group (under 35) in 2004 (before the 2005-2006 housing bubble apogee). Remember that about a quarter of median net worth is not real yet.

The only bad part about learning all this is that you might get upset more often when you see how other people misuse the SCF and similar statistics.

“Savings” Pitch Tricks You into Overspending

More Dark Alchemy:
“News”=Advertising
“Saving”=Spending

Free Money Finance cited a finance article about 15% of US households with $0 net worth. The article is a perfect example of tricking you with slick sales marketing that masquerades as news.

First, however, look at the faulty analysis:

• The article cites 15% of households with $0 net worth but is on thin ice when it converts households to individuals—unnecessarily (what is wrong with simply saying "1 out of 7 households"?).
• The 2.6 persons per household includes babies and college roommates.
• The logical flaw is the article's assumption that a $0 household has 2.6 persons each with $0 net worth. Each household member can be wildly different from one another—think if your roommate were Casey Serin.
• Besides, since about 15% of households are led by a “householder” under 30 years old, 15% of households with $0 net worth is not “shocking” (as the author asserted).

How To Twist “Savings” To Trick You into Overspending

• The author claims “shocking” news to scare you into “saving” more.
• Even more importantly, the pitch actually gets you to spend more money.
• There is no mention of debt reduction. The author ignores the most basic method of increasing net worth (reducing debt), and also ignores basic savings, and skips straight to investments and advertises specific mutual-fund and stock picks.
• Swallowing his advice means that you probably will be paying fees to someone, probably while paying interest (on unpaid debts) and taxes elsewhere along the way.

The Old Borrow-To-Invest Scheme Again: Who Profits?

It is no surprise when someone advises you to do something that would profit him/her (e.g. to buy a mortgage, student loan, insurance, investment, or anything). The strange part is that people continue to fall for it.

If you pay off debt early, the bank gets less profit off you and the stock market does not get to profit off that money either. It is no surprise when the banking and investment industries (including “free” websites that make money off the stock-market culture) urge you to invest instead of paying off debt; they make money off you coming and going.

When your “impartial” friend makes that same recommendation, you might find that you can trace his/her conviction to advice from the investment industry.

Cast a Jaundiced Eye on the Old Spend-To-Save Advice

Investments are great vehicles for surplus funds but do not confuse true surpluses with amounts above minimum debt payments.

You might do all the math specific to your situation and occasionally find a circumstance where borrowing to invest will (1) profit you as well as (2) profit others—but make sure that #1 is indeed part of the result.

Do Not Inflate Net Worth: Ignore Taxes at Your Peril

Hat Tip: Ed provoked this post.

Part of series: Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?

Do not deceive yourself by inflating your net worth.

Yes, it is difficult to estimate some items but it is better to underestimate your wealth and later be pleasantly surprised than to overestimate and lay a trap for yourself.

The taxman cometh.

People often leave taxes and regulatory costs off their liability list but you can be sure that the government will ignore such creative accounting and will not forget to take its slice ("But look, my blog says I don't have a tax liability because I typed it that way.").

Remember what "net worth" is.

Net worth is a snapshot of what you would have if you liquidated now. If liquidating your IRA now would incur a 35% income-tax rate plus 10% penalty, then the accurate net worth of your IRA now is about half of what your account statements say.

To say that you would not liquidate now and things will be different later is to ignore net worth. If you use a non-net-worth measure, do not call it net worth.

It is better to understand the limitations of a measurement than to cook the books.

Even if you somehow accurately predict a $1 million nest egg for retirement and dismiss your tax liability on it as "only" 10%, leaving the tax liability off your books is a $100,000 error.

To estimate what your net worth will be decades from now is a very difficult endeavor because you would have to guess at fluctuating IRA and home values, variable inflation rates, uncertain future income and saving rates, and the competing compounded interest/returns of both investments and debts.

That difficulty is why it is easier to estimate your net worth now with all liablities from current tax brackets and current laws.

Best-Worst Financial Measures: How To Track Your Financial Independence and Security

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.

Next: Give Yourself a Raise: Best Saving Is Not Spending

Confusing Investment with Consumption: Emotional Attachment & Resale Value Transform Gold into Lead

"Practical Wealth V. Phantom Wealth" covered how to measure your financial wealth accurately by accounting for liquidity and stickiness (resistance to change). This article now covers how people reduce their liquidity without realizing it.

Consumerism Alchemy: Turning Assets into Consumption

Most people realize that some assets such as cars depreciate and the depreciation supposedly represents the consumption or usage of the asset in wear-and-tear. However, many people then assume that any retained or core value at any point in time is a positive asset (often for their supposed "net worth")--but people often behave in ways that turns an asset into additional ongoing consumption.

2 ways in which "retained" asset-value becomes consumption:

• The Resale Value Trap: Resale value is an "entry fee" surcharge and should be kept as low as possible. Resale value is a marketing trick to encourage overbuying. Never trading down (liquidating an expensive asset and buying a cheaper one) means that any core value is consumption, an expenditure never to be recouped. Some people fool themselves into thinking that they pay for car depreciation but “keep” the resale value, which is untrue, practically speaking. If you continually trade-in cars when they reach $10k value, that $10k (plus any interest) is forever lost as permanent consumption, an "entry fee" for "getting in the game."
• The Emotional Attachment Trap: Emotional attachment is a form of illiquid stickiness that turns an asset into ongoing consumption. Count your car only if you are willing to trade it for a junker. Otherwise, it is phantom wealth because you would never tap it. Instead of disaggregating the value of basic transportation from surplus conveniences (CD player, etc.), you are treating the whole, indivisible car as psychic consumption. Do not count your grandmother's wedding ring if you would never sell it despite defaulting on your mortgage.

Next: Best-Worst Financial Measures: How To Track Your Financial Independence and Security

Practical Wealth V. Phantom Wealth: Time Your Money

Time Is Money

Timing Is Everything

"Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?" covered how "net worth" and assets can trick you into the illusion of financial health (phantom wealth). Instead of net worth, use realistic measures of accessible wealth to rate your fiscal health. Too many people ask the "How much?" question but forget the crucial "When?" question.

Liquidity: WHEN you have money is as crucial as HOW MUCH.

Try calculating your wealth in the standard money measurements of liquidity to measure how much buying power you actually have at different time horizons, from immediately through the medium and long terms: Make your own personal M0 (“M zero”), M1, M2, and M3:

• M0 = Cash.
• M1 = M0 + checking or other “demand” accounts.
• M2 = M1 + savings accounts up to and including insured CDs (<$100,000).
• M3 = All money.

Compare cash with obligations at each time horizon (week, month, year, before age 59 1/2, etc.--including any withdrawal penalties). What if you lose your job, get sick, wreck your car, or have a house fire? You should have cash for small or likely or short-term events, scheduled liquidity for medium-term events, and use available credit or insurance only for the biggest, unexpected, unaffordable events.

Working Capital a.k.a. Operating Capital

Current Ratio = current assets divided by current liabilities

"Current" means liquid, liquidatable, or due within a time period. A potential pitfall is that, with a time period such as "this year," current assets include expectations of future income: Beware of relying on Accounts Receivable, including future wage paychecks, because they are not "a bird in the hand." If you have been opting for overtime pay recently, that precedent is no guarantee that you always will be able to choose your take-home dollar amount. Do not count your chickens before they are hatched.

Liquidity Ratio = liquid assets divided by expenses
Assume your income suddenly becomes $0. How long would you last? A typical recommendation is a 3-6 month buffer, and the self-employed or irregularly-employed are more likely to keep even bigger buffers for longer lean times.

Accurately Rate the Liquidity of Your Non-Money Assets

Rate the realistic time horizon for liquidating the asset (Week? Month? Year?) before you include it in your appropriate "time horizon" assessment of wealth.

Be very cautious in counting non-money assets because their ownership is "sticky" (resistant to change). The stickiness might be due to legalities such as a car title, or regulations such as car inspection (it is grandfathered but would fail a new inspection), or transfer costs such as a sales tax. Both time-to-sell and sales-price can change with events, such as a CNN expose on how your car model is a death trap.

Even more importantly, emotional attachment is another form of stickiness that confuses investment with consumption.

Biggest Net Worth Mistakes: Is Your Net Worth Accurate or Useful?

Beware Phantom Wealth

Many people misuse "net worth" both on financial blogs and offline. Net worth is a simple snapshot for an immediate liquidation. Positive net worth is "solvent" and negative net worth is "insolvent" (unable to pay all your creditors even if you sold everything immediately). However, most people have no intention to liquidate and misapply the measure for long-term planning. Here are the 3 biggest mistakes that can fool people into false complacency:

1. Paper Profits: Investments have not made a penny until you cash out the profit ("realize" the gain). The housing bubble is bursting and middle-class people are waking up to find that their houses are worth $100,000 less than they thought. 401k profits are unguaranteed against market losses and uninsured against blatant theft. One 61-year-old woman found that her 401k lost nearly a half-million dollars before she knew it and a fraud victim found a 401k account cleaned out at $0. Social Security is no better, as those periodic statements of future payments include fine print that declares the estimates void of any guarantee, and the government rewrites your fictional “account” balance any time it wants by changing the retirement age or changing the calculation formula.
2. Real Costs (Present Value, Future Value, and Time Value of Money): Not only is $1 today worth more than $1 tommorrow in a typical inflationary environment, but people forget that different discounts apply to different assets/liabilities. $10,000 in a mutual fund does NOT cancel out $10,000 of credit card debt if the fund earns 11% but your debt costs 13%. Instead, you would lose about $5,000 over 40 years so, if you are trying to measure your long-term financial health, you should discount your mutual fund to $5k or increase the debt value to $15k (I will adress the misuse of tax-deduction modifiers in a future post). Another dangerous ommission is tax liability.
3. Illiquidity: It is not your money anymore, or not yet, as nowadays so many people sign away rights to their money by chasing tax deductions which restrict access. Whatever money people do not make inaccessible in retirement funds, they trip over themselves to bury in real estate (more on this in a future post).

Phantom Wealth and Broke Millionaires

These factors can result in an alleged paper “millionaire” who cannot make a mortgage or car payment. There are people who complacently carry tens of thousands of dollars of credit card debt because of an imaginary "wealth effect."

As for restricted nanny-state allowances (Social Security, IRA, etc.) and non-money assets (home equity), most people will not convert them into direct buying power until almost 70 years old (relocating home equity from one address to another does not change anything)--and maybe never before they die (when the heirs liquidate the house to pay off the legal, tax, and health-care bills).

Meanwhile, borrowing against assets is a sucker's game.

Resist the urge to borrow against your inaccessible wealth. Paying the interest penalty to borrow against asset value tells you that the asset itself is unavailable, which is why you have to pay someone else to use your own rumored "wealth."

That is quite a trick, being “wealthy” and still having to borrow money. If your "net worth" meant that you actually had money, you could lend to other people and make money by earning interest--instead of losing money by paying interest. Some people pay twice, since they paid an 8% mortgage to "build equity" and then paid another 8% for a home equity loan, which combined is not much different than a 16% credit-card rate. Try defining your wealth by the absence of borrowing.

Next: Learn how to measure wealth realistically in "Practical Wealth V. Phantom Wealth."