Most people are familiar with the concept of net worth which is simply the sum of one’s assets less liabilities. Net worth is the amount reported on an individual’s traditional balance sheet.
Net wealth expands on the concept of net worth by taking into account human capital and the present value of future consumption needs. In other words, net wealth is the present value of all available marketable and non-marketable assets less the present value of all current and implied liabilities. Net wealth is the amount that is reported on the economic balance sheet, the formula is as follows:
Let’s assume that an individual had the following assets on his traditional balance sheet:
| Assets | |
| Liquid Assets | |
| Checking Account | $ 50,000.00 |
| CDs | $ 250,000.00 |
| Total Liquid Assets | $ 300,000.00 |
| Investment Assets | |
| Brokerage Account | $ 400,000.00 |
| 401(k) | $ 700,000.00 |
| Cash value of life insurance | $ 32,000.00 |
| Total Investment Assets | $ 1,132,000.00 |
| Personal Property | |
| House | $ 1,200,000.00 |
| Cars | $ 50,000.00 |
| House Contents | $ 200,000.00 |
| Total Personal Property | $ 1,450,000.00 |
| Total Assets | $ 2,882,000.00 |
Based on this traditional balance sheet, this individual has $2,882,000 in traditional balance sheet assets. On the economic balance sheet, all of these entries would be consolidated into a single asset referred to as financial capital. From there, human capital and the present value of any pension assets would be added to financial capital in order to find the total dollar value of assets on the economic balance sheet.
Let’s assume that based on this individual’s profession, his human capital has a present value of $7,500,000 and the present value of future pension benefits is $500,000:
| Assets | |
| Financial Capital | $ 2,882,000.00 |
| Human Capital | $ 7,500,000.00 |
| PV Pension | $ 500,000.00 |
| Total Assets | $ 10,882,000.00 |
Based on those assumptions, total assets on the economic balance sheet would amount to $10,882,000 compared to $2,882,000 in total traditional balance sheet assets.
Let’s also assume that this individual had the following liabilities on his traditional balance sheet:
| Liabilities | |
| Short-Term | |
| Credit Cards | $ 15,000.00 |
| Total Short Term | $ 15,000.00 |
| Long Term | |
| Mortgage | $ 400,000.00 |
| HELOC | $ 125,000.00 |
| Total Long Term | $ 525,000.00 |
| Total Liabilities | $ 540,000.00 |
Based on the traditional balance sheet, this individual’s net worth would be $2,882,000 – $525,000 = $2,342,000. Now, let’s calculate and compare the difference between net worth and net wealth.
On the economic balance sheet, the total dollar value of liabilities would be entered on the economic balance sheet as a single entry referred to as debt. In addition to debt, the economic balance sheet takes into account the present value of all future consumption needs.
Let’s assume that the present value of lifetime consumption needs amounts to $5,200,000, based on this individual’s lifestyle:
| Liabilities | |
| Debts | $ 540,000.00 |
| PV Lifetime Consumption | $ 5,200,000.00 |
| Total Liabilities | $ 5,740,000.00 |
Based on these assumptions, economic balance sheet assets amount to $5,740,000 compared to $540,000 in traditional balance sheet liabilities.
Given the numbers above, we can now calculate this individual’s net wealth, which amounts to $10,882,000 in economic balance sheet assets minus $5,740,000 in economic balance sheet liabilities, for a total net wealth of $5,142,000.
In short, give the assumptions above:
net worth = $2,342,000
net wealth = $5,142,000
Conceptually, two individuals could have the same exact net worth, but their economic net wealth could be vastly different after factoring in income potential and lifestyle needs. In essence, the difference in total net wealth between two individuals with identical net worth may result in different investment strategies, and tolerances and attitudes towards risk.
The Excel file used to calculate net worth and net wealth can be found here.
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