The secret to building long term wealth is a simple tool that has been around for ages.
The secret to wealth is optimizing your personal balance sheet.
You mean a budget?
No, not a budget but I can understand why you would think so. For a very long time, those in the personal finance realm have touted a budget as the sure-fire way to manage your money in a way that will allow you to build wealth. But it isn’t working.
Nearly 70% of Americans have a budget but only 60% of us could cover a $400 emergency expense! So all of that budgeting isn’t even allowing us to cover a relatively inexpensive emergency expense, never mind build any kind of long-term wealth.
What a budget does
A budget to us as individuals is very similar to a profit and loss statement (P&L) to a business. A P&L is a summary of the revenue (a fancy term for sales), cost, and expenses incurred for a specific period of time. It gives information about whether or not the company can make a profit by increasing revenue, cutting costs, or both.
For us, as individuals, our revenue is our income, our costs are our necessary expenses (housing, transport, insurance, etc), and our expenses are our discretionary expenses (food, clothing, entertainment, etc). Our specific period of time is typically one month.
These functions are important. You need to know how much money is coming in, how much is going out, and where that money is going and a budget shows you that. But a budget is missing some pretty critical information if your goal is to build wealth.
A budget is missing some pretty critical information if your goal is to build wealth.
What a balance sheet does (for a business)?
A balance sheet shows a company’s assets & liabilities and shows how effectively a company’s management team uses the company’s resources.
Assets include cash and cash equivalents, liquid assets like Treasury bills, accounts receivable and inventory.
Liabilities include short and long-term debts, lease/rent commitments, accounts payable, etc.
Shareholder’s equity is equal to a company’s total assets minus its total liabilities. It is the amount that would go back to shareholders if a company’s assets were liquidated and its debts paid off. Shareholder’s equity is one of the markers indicating how financially healthy a company is.
Did you spot the missing information? For us, our assets are things like our investment accounts and the equity in our homes, our liabilities are our debts, and shareholder’s equity is our net worth.
A balance sheet contains this critical information while a budget does not.
But you’re not a business
You are though! Your personal finances are a business, the business of you. Money comes in, money goes out, you have assets, you have liabilities and you have a net worth. Would a business be successful if it just tracked what money came in, what money went out, and where the money was going?
Businesses use a balance sheet to show a much more complete picture of their finances and you should too. A balance sheet gives you that 1,000-foot overview of your financial health, providing much more data than a budget can provide.
What gets measured gets managed
A balance sheet will show your net worth. Net worth is your total assets minus your total debts or liabilities. A budget doesn’t show any assets, just your monthly income. Here is an example:
- Assets: $240,000
- Debts: $130,000
- Net Worth: +$110,000
If you have more debt than you have assets, you can have a negative net worth. Net worth is arguably the most important number in personal finance. Here are 4 reasons why you should track your net worth.
1. Focus on increasing the value of your assets
Assets can include equity in other people's business (stocks), giving loans to companies & governments (bonds), equity in your own business (founder equity), income generating real estate, etc.
You’re not going to get rich renting out your time. You must own equity - a piece of a business - to gain your financial freedom. - @naval
2. Avoid anxiety and knee-jerk decisions
The stock market crashes by 20% and you start feeling anxious. You are tempted to sell and get out. Your mind tricks into believing that everything is going to zero. You come back and check your net worth. You notice there is only a slight change in your net worth because stocks were only a part of your overall portfolio.
You avoid a costly mistake.
3. Keeps you motivated
Month to month you might see small changes, but over a long period of time, you’ll see how your delayed gratification sacrifices have added up.
It feels validating.
4. Shows when you are ready to retire
The simplest and most obvious reason to track your net worth is to find out when you are ready to retire. Typically, you can live off of 4% of your total investments safely for a 30-year retirement. A simple way to calculate your target number is to look at how much you want to live on per year and multiply by 25. For example, say you want to live on $100,000 a year, $100,000 x 25 = $2.5M. Once you have that invested, you are ready to retire!
So, what is the secret to long term wealth?
Tracking your net worth and doing something about it every month, every year.
Kubera helps you protect your wealth by keeping track of your net worth and storing important documents. It also ensures safe transfer of this critical information to your beneficiary, if something unexpected happens to you. Read the story behind Kubera.
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