How Net Worth Works

Perhaps the biggest misunderstanding we see on the internet is the idea that wealthy people - let's just say, a billionaire - is sitting on a literal billion dollars in a bank account somewhere, ready for the spending.

This isn't how that works at all.

a) bank accounts aren't insured for that much, so it'd be a bad idea and not really what banks do.

b) if it's sitting in a bank account it's not making interest, which is the whole power of having big lump-sums of money: it earns more money by itself.

c) and most importantly, it misunderstands what net worth is and how it's calculated.

What's in a Sum

At a high level, your net worth is the positive assets you've got minus any debts you owe.

For us normal people, that usually means the sum of our bank accounts plus some retirement investments, plus maybe a car and some miscellaneous valuable goods, plus part of a house that we've paid off is summed up as a total, and then the negatives like student loans, the other half of the mortgage, car loans, credit card debt etc etc are summed as the negative.

So if you own $100k in positives and $30k in debt, your outcome total net worth is $70k.

This is pretty straightforward and intuitive for us at the scale of normal salary-taking, bill paying middle-class types.

Mortgages and Assets

This might have to get broken out into a mortgage-specific post, but for now:

You don't own a house until you've paid off the last cent of the mortgage. The bank owns the house until then, and you're just living in it paying rent in the form of interest to the bank.

But for the sake of your net worth, you have some equity in the house as you pay it off. In the beginning you're paying very little towards the sum as it's mostly interest, but eventually you pay more and more to the principal (the cost itself). Just for fun, I plugged in a mortgage calculator: $300k house @ 3.64% means the first year payments are $621 principal and $898 interest (per month), and by year ten it flips. The graph of the whole switching makes a sort of arc - as you pay more off there's less interest.

So you can do the math: at the end of the first year you've spent $18,240 but own $7452 in equity - the amount of principal paid off. By year 10 you've spent $182k but own $88,752 in equity.

The other $93k is just interest that was paid to the bank, so while you spent it it's not really worth anything. You don't own it, you can't resell it. It's not equity. It's just a payment.

But the equity - this real value, not the house's value - is the part of your net worth that's actually useful.

So too with cars, if there's loans on those, but cars also have a sharp depreciation curve, so what something is worth in the end changes as well as where you're at in the interest payments.

Investments

This ties into the main investment page but just to say: as you increase your net worth you want to put it to work because you're not a movie villain with it all in one bank account like a dummy. You want the money to make more money and so you invest it.

Any money in those accounts is also part of your net worth, but it's considered less liquid - meaning, you can't spend it directly like cash. It's less available.

Although honestly, a lot of modern investing is awfully easy to convert back; I could withdraw my TFSA accounts in an emergency and have the money in my bank account within a few days. Great. In the old days with brokers and stodgy financial institutions this whole request process might take weeks or months, but we have the internet now and modern bank transfers are awesome and often zero-fee.

Other less liquid investments might be things like physical gold you bury in the backyard or real estate that you own and rent out as a landlord. A business you invest in, a personal loan you give a friend: it's money that's out there ostensibly earning returns and/or interest but if you wanted it back right now you'd be out of luck. These things are part of your net worth but aren't directly spendable, so they're just sort of a virtual value: contributing to the total sum but never used for day-to-day purchasing decisions or practical concerns.

Higher and Higher

Higher wealth makes things weird.

When you start a company you own all of the "stock" in that company: any success it grows is 100% yours (other than taxes) and so it's directly part of your net worth. The value of a company is value you own and control directly.

As the company grows, traditionally, you hire people and dilute your control of it. Maybe you bring in a partner and now you own 50/50 of the company, maybe you offer them 10%, whatever. The ultimate goal is that while you now only own 90% of your value, the value itself can increase because of the work done by the other people such that you both succeed upward in growing the business.

You own a smaller share but a bigger total value as the company itself is worth more over time.

This happens over and over as more and more people are hired and eventually the company "goes public" which is to say, random strangers can also just buy stocks at will on the stock exchange. Up until now it's always been private deals with specific terms for specific employee-esque people. Now it's up for trade.

Jeff Bezos owns about 16% of Amazon. As of today the Amazon stock is worth $1637, so that multiplies out to 129 billion. But that'll change by tomorrow, and again by the end of the week as the stock price fluctuates by the minute. He literally gains and loses millions of dollars every hour simply because the forces of people buying and selling stocks is directly tied to that multiplication factor.

What Jeff doesn't have is 129 billion just in his bank account. In fact, it's not even money. You can't go to the store and buy milk or a Ferrari or donate to starving kids in Africa with Amazon stocks. It's less liquid than me owning stock in Amazon as some random internet trader who can cash it out fairly fast.

This is why the whole "these evil billionaires can't be bothered to help the common man!" rhetoric is inherently impractical: they legally, literally can't spend their net worth even if they wanted to. If you somehow staged a populi coup and took over, you'd be equally useless at redistributing this supposed money, because it's not really anything but value stored in a company that has to continue to exist in order for that value to be worth anything.

It's also why he legally can't sell large chunks of it at a time: if Jeff suddenly wanted to retire and cash out, he can't just take his 16% as dollars and run. a) the cash doesn't exist like that and b) there's protections against CEOs doing exactly that because they represent key roles in the entire country and global economy.

If you have a 401k with your employer, if you've invested in an RRSP or hold really any sort of savings fund that earns interest, you almost certainly own a tiny bit of Amazon stock indirectly.

Deciding to leave, the shutter the company, would collapse that value and the shareholders would rush to cash out their positions and the whole thing would go to zero, other than whatever the physical value of some office buildings and warehouses and stuff is worth, but nominally zero relative to the value of a global business selling goods to everyone on a daily basis.

So as part of that legality, CEOs and top shareholders, company insiders are allotted a sort of allowance: they're allowed to cash out stocks they own up to a certain maximum that wouldn't illicit fear and panic in the system and especially wouldn't allow them to cut and run completely.

Over the years, as this is public record, Jeff has cashed out a few billion for himself, on top of his normal salary which is honestly pretty normal even with extra compensations (it's listed as $86k a year, but probably more like ~$1.5 million which isn't crazy considering top programmers and the like can easily earn a million themselves)

So he's worth, in practical spending terms, his liquid-worth is about as much as half the revenue of the Salvation Army, 37% of the YMCA, akin to Habitat for Humanity or Boys & Girls Clubs of America or a whole list of others.

What Wealth Really Is

So we can see how there's liquid and illiquid net worth: there's things that count as part of your total sum but aren't really spendable or divisible into useful spending money.

We can see how houses and cars that have significant loans on them can count against you in total.

Things like student loans are straight debt, counting always as negative values. They might be investments towards better jobs, maybe, such that your earning potential goes up and you can make more over time once they're paid off, but for now the value is simply the number, and it's negative.

But what wealthy people do that others don't is that they look for things that appreciate in value.

They're looking for real estate that earns, they're looking for collector cars that'll go up even as they're being driven and enjoyed. They're looking for businesses to invest in and foster, they're buying art because it's a weird meta-store of value. It's a game that not many people recognize or see.

Anyone can spend money and it just disappears, it takes a bit of knowledge and skill to spend money and then get more money out of it in the end.

To some extent the secret of net worth isn't the value, it's the flow. The direction and vector of travel.

If you have a small amount but it's continually growing and equity building, you're on your way.

If you have a large amount and it's being squandered, you'll end up broke eventually.

There's an old quote that's something like "everyone wants to be a millionaire, but what they really mean is that they want to spend a million dollars. You can't do both."

In the end, like all things, it's merely about deliberate stewardship.

And not keeping millions in cash in a bank account, because that is so dumb.