What Should Your Net Worth Be? Why “The Millionaire Next Door” Equation Falls Short – And What A Better Thumbnail Calculation Might Look Like

Recently, I was reminded of the first book I ever reviewed on The Simple Dollar, The Millionaire Next Door. I really liked the book, even though there was one big flaw in it: a rather large age bias. The book was written for people over forty, from top to bottom.

This was most obvious when the book offered up a formula for calculating what your net worth should be:

Target Net Worth = Age X Annual Pre-Tax Income / 10

So, let’s say I’m a 23 year old, fresh out of college. I am carrying $25,000 in student loan debt and my only asset is my car, but I get a job paying $30,000 a year. According to this formula, this is my net worth:

Target Net Worth = 23 X $30,000 / 10 = $69,000

I don’t know very many fresh college graduates with a net worth that high – most are saddled with a lot of student loan debt and simply haven’t been in the workplace long enough to build any assets.

What can we do to change that? The big question is really how old should a person be when their net worth switches over to positive? For the average college graduate, that’s going to be at least a few years after graduation, no matter what. So let’s try this instead:

Target Net Worth = (Age – 27) X Annual Pre-Tax Income / 10

That gets a more realistic number for young people – our straw man above would have a target net worth of -$12,000, which is pretty realistic – and even if a person chooses graduate school, the number isn’t too far off.

The problem pops up later on in life. At age 40, with an annual salary of $40,000, a person would have the following target net worth:

Target Net Worth = (40 – 27) X $40,000 / 10 = $52,000

A person who has been earning $30K to $40K over fifteen years or so should definitely have a higher net worth than that. The culprit, I think, is that number on the bottom – 10. It assumes that a person’s net worth should only grow 10% in a given year. What will actually happen is once the net worth starts going positive and growing well, it will grow by more than 10% each year. My net worth, for example, will probably grow somewhere around 30% this year.

So let’s say we think a financially healthy person, once they’ve paid down some of their debts, should see their net worth grow by significantly more than 10%. Let’s try making that number on the bottom 5 instead of 10.

Target Net Worth = (Age – 27) X Annual Pre-Tax Income / 5

For our straw man, at age 23 with an income of $30,000, his target net worth would be

Target Net Worth = (23 – 27) X $30,000 / 5 = -$24,000

This is probably a pretty good estimate, considering he graduates with $25,000 in student loan debt and owning only his beat-up car. The new equation is far more realistic for people in their twenties and thirties than the old one. What about the 40 year old with an income of $40,000?

Old Target Net Worth = 40 X $40,000 / 10 = $160,000
New Target Net Worth = (40 – 27) X $40,000 / 5 = $104,000

Even at age 40, the new equation points at a lower target net worth. But what about a 60 year old with an income of $60,000?

Old Target Net Worth = 60 X $60,000 / 10 = $360,000
New Target Net Worth = (60 – 27) X $60,000 / 5 = $396,000

Late in life, the modified equation actually points at a higher net worth than before. I think this is a much more realistic model because of the power of compounding – compounding is going to be much more powerful for you later in life as you’ve been building up your retirement and such.

So, instead of using the equation found in The Millionaire Next Door to figure your net worth, try this one instead:

Target Net Worth = (Age – 27) X Annual Pre-Tax Income / 5

It creates a much more realistic view of a person’s financial state throughout their life than the original, particularly for younger people. No single thumbnail formula like this is perfect – I’m just seeking one that matches better than the one in the book.

I recommend using this number as a target throughout your life, much as The Millionaire Next Door suggests: make it a goal to try to double the target or better, but know that if you’re matching the number, you’re doing all right.

http://www.thesimpledollar.com/2007/09/16/what-should-your-net-worth-be-why-the-millionaire-next-door-equation-falls-short-and-what-a-better-thumbnail-calculation-might-look-like/