The following is an excerpt from Securing Your Financial Future: Complete Personal Finance for Beginners courtesy of Rowman & Littlefield Publishers. All Rights Reserved.
If you want to know how tall someone is, you have them stand on a level surface, back against a wall, then make a mark on the wall and get out a tape measure. If you want to know how much someone weighs, you have them stand on a properly calibrated scale. Simple, right?
But what if you wanted to measure someone’s financial condition? When I said earlier that our goal is to achieve a strong financial position, what did I mean by that? How is personal financial strength measured? What is the equivalent of inches or pounds when it comes to personal financial health?
It’s an important question, because you won’t be able to tell if you’re succeeding unless you’ve got a way to measure your progress. To find your way using a map, the first step is identifying the you-are-here point—and knowing where you are requires a measurement.
The way we measure personal financial health is called net worth. Net worth isn’t an opinion or an impression; it is a very well-defined measure with a specific definition that is widely accepted. We’ll describe how to calculate it shortly, but before we do, most people find it helpful to understand it conceptually first—and for that, we need an analogy.
The Net Worth Bathtub
Think of an ordinary bathtub. When you turn on the faucet, water runs into the bathtub. The water will stay in the tub until the drain is opened. This tub has a really big drain, and it is adjustable. So it is possible to drain the water out more slowly than it is coming in, faster than it is coming in, or at exactly the same rate. Got it?
You’ve probably already figured out that the faucet represents money coming in. This is income from all sources: the paycheck from your job or jobs, your lottery winnings, gift checks from your grandparents, whatever. The drain, of course, is money going out: paying your bills, buying airplane tickets, money in wallets that you lose, and so on. Obviously, when water is coming into the tub faster than it is draining out, the water level in the bathtub will rise; when water is draining out faster than it is coming in from the faucet, the water level will fall.
Now here is the point: when it comes to personal financial management, what we care about most is the water level in the bathtub. The water level in an individual’s bathtub represents that person’s net worth. Other terms for a high water level are rich or wealthy. So the object of the game is to increase your net worth. Fill up that bathtub! All that we have talked about, and will talk about, are strategies to increase your net worth. Any financial decision that you make should be made with net worth in mind.
Some very important realizations are apparent from the bathtub analogy; in fact, they’re so obvious that they hardly need to be pointed out. If you want the water level in the bathtub to rise, then the drain has to be adjusted to a rate that is slower than the faucet is running. And the longer the drain is running slower than the faucet, the higher the water will rise. Stated a different way, it isn’t the absolute rate that the drain and faucet are running that is important—it is the relationship between the two.
Common Misconceptions
Even though these implications are quite readily apparent when it comes to bathtubs, it is amazing how murky people’s thinking can get when applying the same ideas to personal finance. The two most common misconceptions are to confuse either the faucet or the drain with the water level. Let’s look at them one at a time:
Misconception #1: The faucet is all that matters. A fast-running faucet means a really high income, right? In many different ways, the faucet gets so much publicity that it is easy to see how some people get the idea that this is really the only important goal. In our culture, a high income is regarded as prestigious or even glamorous. Controlling expenses and being thrifty (or watching the drain closely) are often regarded as the opposite—only for those with very low incomes.
Anytime income tax rates are in the news, the news media like to refer to people in the higher income tax brackets as “the rich.” This serves to further the misconception that high income automatically means high net worth.
High earners in the upper tax brackets may or may not have parlayed that high income into substantial wealth; it depends on how well—or not—they have managed their drain.
Misconception #2: The drain is all that matters. A fast-running drain means lots and lots of spending. If we see someone who is driving a luxury car, maybe even has a few extra cars, lives in an expensive home, and takes a lot of extravagant vacations, it is not uncommon to hear their neighbors conclude, “Oh, that person is really rich!” (In fact, one of the main reasons that this person buys all those things may be precisely because he or she wants the neighbors to say that.)
The idea that a wide-open drain is proof of a full bathtub is regularly reinforced culturally, too. It is a favorite theme of advertisers; after all, it doesn’t do the advertiser any good when you tighten your drain controls. Their job is to get you into a “spend spend spend” frame of mind. It’s also a favorite theme in most popular entertainment. A rich-looking hero speeding away from his or her mansion in an ultra-hot sports car probably captures your attention a little better than one who is huddled over a spreadsheet, intently preparing next month’s budget. Just remember: your financial life is not fictional. Advertisers and media have their agendas, and that’s fine—you have your own.
Despite these misconceptions, the truth is pretty easy to understand when you think about the bathtub analogy. Neither the faucet, nor the drain, is the be-all and end-all when it comes to increasing net worth; it is the relationship between the two. A fast-running faucet provides a better opportunity to increase net worth, but it won’t happen without proportionate drain control. Watching expenses carefully may not be portrayed as something that wealthy people need to be concerned with, but controlling spending is essential to building a high net worth.
A famous book titled The Millionaire Next Door by Thomas J. Stanley featured detailed, survey-based descriptions of the lifestyles of the wealthiest people in the United States. In fact, the subtitle of the book is The Surprising Secrets of America’s Wealthy. By now, you might be able to guess what the surprise is: the most common profile of America’s wealthy does not conform to either the big faucet or the big drain stereotype. In fact, it is surprisingly common for those with big faucets to fall into a big-drain habit that leaves them with only modest water levels. Instead, it is quite a bit more common for wealth to be built by consistent drain control. Most of America’s wealthy turn out to live in much less expensive homes than they could afford, to buy used cars, and to generally avoid any spending that could be considered extravagant.
Does this surprise you? It is certainly a very different picture than the way that “wealthy” is usually portrayed in the popular culture. But it makes sense when you think about it, using the bathtub analogy. In a way, it is a classic illustration of the old saying “You can’t have your cake and eat it, too.” America’s wealthy have their cake. America’s biggest spenders have eaten most of theirs, and now it’s gone.
Take a minute to think about this . . . it is really important for this point to sink in. Once it does sink in, you’ll never think about spending money in the same way again. You’ll stop associating spending with what it can buy you today; instead, you’ll view spending as lost opportunities to save, invest, and grow your net worth. This way of thinking will then become a powerful transformational habit for you. If you want the freedom to retire early, or to weather any kind of unanticipated financial storm, or to be in a position to help those close to you if needed, you’ll want to have most of your cake left. That means that you’ll have to keep a careful eye on how much of it you eat—plain and simple.
very well explained the formula...
perfect line for conclusion = ""view spending as lost opportunities to save, invest, and grow your net worth""
Posted by: Jim | May 29, 2012 at 09:18 AM
Good article-- now if I can just find a plug big enough for my drain:(
Posted by: Denise Gabbard | May 29, 2012 at 11:16 AM
This article provides a good analogy to look at accumulating net worth.
Of course there is nothing wrong with a financial bathtub overflowing which is where the analogy breaks down...
-Mike
Posted by: Mike Hunt | May 29, 2012 at 11:18 AM
When measuring your financial health it makes a lot of difference just where you are in your life, what your responsibilities are, and what kind of lifestyle you plan to lead. Everything changes as you progress from starting your first job, to getting married, starting a family, buying a home, achieving your goals, and finally retiring. At 77 and 79 we have been through the whole cycle and everything turned out very well.
Your traits are the biggest factor. Have you been raised by parents that managed their money well and are financially secure? Are you willing to live frugally, well within your means, or are you a "Want it all now" type of individual.
One of the actions that will have the biggest effect upon your financial health is your choice of living partner. Two people that are on the same page with their financial aspirations are the best. A spender and a saver is a deadly combination and a formula for eventual failure, as are two spenders.
Posted by: Old Limey | May 29, 2012 at 11:31 AM
Jim and Denise - thanks! Oh, and Denise - a lot of that drain anxiety going around these days! But identifying drain management as the problem is the key, many people just don't see it that way, or don't want to. Now that you have, just stick around FMF for a while and you're sure to get lots of great ideas!
Posted by: Chris Smith | May 30, 2012 at 12:26 AM
Limey, couldn't agree more about the "stage of financial life" being a key consideration. That's one reason why I chose to write Securing Your Financial Future specifically for YOUNG ADULTS just starting out in their financial lives. Especially now, with pension-style retirement plans all but gone and Social Security on shaky footing, it's never been more important for financial newcomers to get off to a strong start!
Posted by: Chris Smith | May 30, 2012 at 12:27 AM