Wednesday, September 6, 2006

Calculate Your Expected Net Worth

So you have some savings socked away (or not, oops), but maybe you're wondering how it compares to others of your age and income, or maybe you want to know if you'll be able to retire on that amount of savings. (Twenty-two-year-olds are allowed to think about retirement savings, right? :) ) I've done a bit of reading on the subject (though, notably, I've not read the recent "The Number" books out there). Below are two formulas I've found for estimating expected net worth.

My opinions of these formulas reflect the fact that I'm new employee in the workplace and thus my "expected net worth" calculations are very susceptible to certain assumptions made by the formulas.

A Very Rough Formula

I first came across the notion of "expected" net worth while reading The Millionaire Next Door by Thomas Stanley and William Danko. (The link is an Amazon Affiliate link, FYI -- full disclosure and all that.) In their book, they suggest the following formula to calculate your expected net worth:

expected net worth = (age)(gross income) / 10 - inheritance

(Normal mathematical precedence rules apply.) So they're saying that inheritance doesn't count, for one thing; your expected net worth is how much you have contributed, not how lucky you were that a rich relative liked you and kicked the bucket. Fair enough.

What I dislike about this formula, however, is that it's very wrong for youngins who haven't had a chance to earn much money yet. According to the formula, I should have a net worth of $44k by now. But I've only had 3 summer jobs so far! How in the world does it make sense for any 22-year-old but a college entrepreneur to have had a chance to amass that kind of net worth? Especially considering many college students will have a negative net worth from student loans and/or credit card debt until they hold down their first full-time job.

They don't give an explanation of how they derived this formula, so here is my own interpretation. Most personal finance books and blogs advise you to save at least 10% of your gross income. (The more you can put away, and the smaller the percentage of your income your can comfortably live on, the better.) So at 10% savings goal would explain the "(gross income) / 10" term. Multiply that by each year you've been saving, and don't count inherited money in the total. The formula overstates how many years you've worked and it doesn't take into account compound interest. Perhaps Stanley and Danko hoped the over- and underestimates would balance out?

To be fair, the authors do state that they have a super-duper fancy formula they use in their own research, and that this formula is just a quick-and-dirty version. Still, why do they not say "working years" instead of age? If I claim I've worked an entire year at my gross income (which I haven't), I'm suddenly above their "expected" value. If you're more like whatever their typical case is, then perhaps this formula may still give you useful values. (These shortcomings are also discussed on Old Niu's blog.)

A Better Formula

A second formula is presented by Marotta Asset Management via the blog Free Money Finance:

adult years = age - 20

expected net worth = (adult years / 240 + 0.1)(adult years)(gross)

Change the adult years calculation if you started working at an age significantly different from 20. I used the formula as-is, and the number it gives me still seems reasonable. YMMV. This second formula was also presented without an explanation of derivation.

For example, this formula says my net worth should be 0.217 times my annual gross income, or $4.3k. This seems much more reasonable for a 22-year-old to have accomplished. I have no sense of how much an older person with a higher income should be expected to save, so I can't comment on how well this formula or the Stanley and Danko one works for other demographics. (But do check out MSN Money's article for some median figures of different age groups.)

Note that, technically, the Marotta formula isn't meant to show your net worth. It's meant to say how much you should have saved by the time you retire (they assume at 72) in order to live off your savings at your current income level. Think of this number, then, as a minimum expected net worth; you may well have other investments and assets that push your total net worth higher by that age.

Conclusion

Neither of these formulas cope well with people whose income is currently in flux. Obviously, a more advanced analysis would be needed to take each year's individual gross into account. But if you're looking for ballpark figures, plug your age and income in and see what comes out. In any case, the end result will likely be the same: save more, spend less.

Update, 9/11: Based on a comment by Debbie, I've created an Excel spreadsheet that takes into account varying income levels per year. Suggestions for improvements welcome!

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3 comments:

Debbie said...

Yes, the simple formula from _The Millionaire Next Door_ is too high in the early years (because, as you said, you haven't had time to earn that much) and too low in the late years (again, as you said, because of all the compounding). (Being in my middle years, the two formulas you provided work out to be about the same for me.)

I also have a problem with basing everything on current gross income. This is what makes the calculation simple, but it's so sad that when you get a raise it suddenly makes your net worth look worse.

What I do is go with the assumption that I should be saving 15% of my income (like millionaires do, according to that book) and earning at least 8% on my investments.

I use a spreadsheet. In the left-hand column, I list the year, starting the first year I had a job.

In the next column I list my income for that year. This is the hardest part since I didn't start this until I had already been working a couple of decades, so I just took the figures from the statement the IRS sends out each year. I don't, therefore, have all my babysitting earnings, etc.

In the next column I list what the net worth should be at the end of that year. For the first year, that would just be 15% of the income for that year (=[income]*0.15).

For the other years, I assume the net worth from the previous year grows at 8% AND that I save 15% (=[previous year's net worth]*1.08 + [this year's income]*0.15).

This method gives me a number that's a little higher than the other two but still quite reasonable.

To calculate my expected net worth in future years, I assume my income increases at 3% per year (based on inflation) for a conservative estimate. You have to be careful, though, because those numbers will look bigger today than they will later because of inflation. To get that same number in today's values, assume your salary stays the same each year.

Arthaey said...

Debbie said: I use a spreadsheet.

Thanks for posting how you take into account changing income levels! I've made myself an Excel spreadsheet like you describe. Do you have any other suggestions on how to make my spreadsheet better?

Duane Gran said...

I too have issues with the formula, but I believe the authors of the book try to use it in two ways:

1) To explain a common trend among the millionaires they interviewed. They find that most wealthy people invested at least ten percent of their wealth.

2) For the multitudes who wonder if they are track to become wealthy, the formula may be useful. However, it only works if you have been working for about ten years. A doctor or lawyer fresh out of school with little savings, school loan debt and a high initial salary will appear to be destitute with the MND formula.

I suggest taking to heart the spirit of the formula, which is to say that you need to save at least 10% of your income in order to become wealthy. Do this and gradually develop more investing acumen over time. As this happens the formula becomes irrelevant for other reasons, namely you will develop a more personalized sense of what is required to live well on your investments. No one can create a formula to answer that question but you.