I will be discussing the concept of personal financial worth in this post as it tie in personal asset allocation modeling.
I will define three categories tied to this concept: “current financial worth”, “long term financial worth” and “worth”.
Let’s start by examining “current financial worth” (the easy part). One way I could express the building blocks of current financial worth would be to divide them in groups of financial assets: capital market assets (e.g. bank accounts, brokerage accounts…), real assets (e.g. houses, second homes, cars, boats…) and finally illiquid/contingent assets (e.g. art, pension benefits, insurance, wine cellar…). Let’s not forget the liability side, liabilities being measured as what’s borrowed in the past that is still outstanding (e.g. mortgages, home equity lines, loans, credit cards…). From here we can sum all assets and subtract them from the total liabilities to get a snapshot of your “current financial worth”. Easy enough, but there are challenges. Those challenges are mainly associated with keeping an up to date inventory and a mark-to-market of this inventory. This mark to market can be especially tricky to find and maintain for illiquid and/or contingent assets.
Now what about estimating your long term financial worth? I choose to define your long term financial worth as the present value of the terminal value of your current financial worth at death. If I want to complete this exercise I will need to estimate your earning power and your expected consumption path. Said in other words, how much you will earn and spend in dollars every year and present value this back to today. In order to go about this I will need to know about the future you. Some of the questions that arise are : what will be your work, marriage, kids and health, inflation, global economy, capital market … . These measures are very hard to estimate as they carry in most cases significant intrinsic stochastic uncertainty, modeling this uncertainty is still in its infancy. To know your financial worth you must go through a Monte Carlo simulation (or some other type of stochastic estimation). The younger you are, the harder the exercise is.
I would end with the following thought. What is your worth? I define worth as the intangible attributes that come with the choices you make through life and how they impact who you are, how you perceive yourself and how others perceive you. It is a very personal question to be answered by each of us, but I would not advise you to tie it to your bank account balance or your earning power. Yet many people will make great sacrifices in order to achieve shorter term financial stability and what is perceived as financial success, at times working against long term financial worth and sometimes their own worth.
Ultimately, measuring financial worth and deciding your asset allocation is an exercise in thinking about the future. When working through the optimization process between current financial worth and long term financial worth it is important to keep your worth in perspective.