Mental Accounting In Net Worth Calculation
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I’m seeing a wave of bloggers and forum members proposing a radical way to redefine “net worth”, where the primary residence is removed from the formula. Say you own a $200k investment portfolio, a $400k home and a mortgage of $100k; the new net worth calculation would simply be the $200k investment portfolio. Everyone is entitled to her opinion, and I respect that. For my own net worth calculation, I prefer the more traditional definition, mainly because I don’t share the same rationales for redefining what’s been working all along:
“The home doesn’t provide me with income.”
The home is every bit an income-generating asset as your investment portfolio, albeit your primary residence operates in a stealth mode where you can’t readily admire its income as you would with your portfolio. That’s because the income generated is in the form of rents-saved. You’ve heard of the expression “a dollar saved is a dollar earned.” If your home is saving you $1,000 in rent, that’s equivalent to earning $1,000.
“I need a roof over my head anyway”
Similar argument here. The investment portfolio is every bit a necessity as your home, otherwise house-rich and portfolio-poor individual would simply starve. Moreover, many of the stocks in our portfolios do provide essential services. We shop for groceries Loblaw’s, pump gas at Petro Canada, bank at Royal Bank, insure ourselves at Manulife, and pick up prescription drugs at Shoppers, but we wouldn’t dismiss these stocks from our net worth, so why dismiss our homes?
Mental accounting
This can become a classic case of mental accounting where “individuals divide their current and future assets into separate, non-transferable portions. The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors.”
I avoid compartmentalize my assets. When I receive a windfall, I’m indifferent whether to pay down the mortgage, or invest within my portfolio. In the end, money is fungible. The same wallet funds both my home and my investment portfolio to achieve the same common goal: financial freedom. I’ll conclude with a quick example outlining the awkward disparity when compartmentalizing assets into different buckets:
Twin brothers having identical balance sheets: $200k portfolio, $400k home and $100k mortgage. They both receive a $100k windfall. Brother A pays off his mortgage completely. Brother B decides to increase his “net worth” by topping up his portfolio to $300k.
Would you deem brother B having a richer net worth? But, he still owes $100k in his mortgage, while brother A is debt-free. Taking one step further, brother B becomes stock-bullish and plunges $200k worth of Home Equity into his portfolio. Now he holds a $500k portfolio, but clearly his is not thriving as the mounting debt is impeding his progress.
The example demonstrates that measuring your net worth solely based on the investment portfolio gives you a narrow view of your overall financial health. The proposed new definition curtails net worth as a tool to benchmark between peers, or to gauge of your financial progress.
I think there’s already a perfectly good term tjat cam be used to define net worth sans your primary residence - it’s known as “net investible assets”. It’s a pity that so many people feel free to “redefine” things to sui their own biases - it only adds to confusion. A worse example is how Kiyosaki redefines “asset” to exclude things that don’t generate a positive cash flow. By this definition my stock portfolio went from being an asset when it wasn’t geared into being a liability when I used a margin loan to increase the size of the portfolio and in the process pay more tax-deductible loan interest than is now coming in a dividends. This ignores the fact that over the long term I’m getting a lot more benefit from capital gains than I would have gained from receiving dividends on the smaller ungeared portfolio.
Regards
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