Foreword
Nowadays, it seems everybody is chasing net worth — trying to be the next millionaire, billionaire, trillionaire, etc. I’ve talked to multiple people, all of whom look only at the balance of their portfolios, completely disregarding things like risk, liquidity, etc.
Thinking like that really only works when you have an infinite capacity to take on risk (which generally means you intend to live forever, amongst other things). Otherwise, it is important to remember that not all net worth are created equal.
Are you really rich, if you have $100m on paper, but are not allowed to spend a single cent of it?
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Fatal flaw
I was talking to a financial products sales person today, trying to sell me on a variable universal life insurance. Essentially, money put in is invested in some stocks of my choice, and grows completely tax free. Withdrawals are tax free, and on top of everything, there is a life insurance component.
They made a really good case — on paper, the product outperforms a traditional brokerage account, assuming you hold the same stocks in both, due to the tax advantage, which generally out shadows the insurance premiums. However, it has a (literally) fatal flaw — in order to completely withdraw everything from the account tax free, I’ll need to die.
Wait… what?!
My understanding is that the insurance component of the product is what keeps the withdrawals tax free. If I take out all the money before I die (i.e.: cancel the life insurance), then all the gains are immediately taxable. So, while on paper, after 8 years of contributing $100k per year, I can withdraw up to $4m from the policy after 30 years, with a $7.1m death benefit, in practice, I can really only take out $3.2m — taking out any more will risk leaving too little to fund the insurance premiums, which then triggers taxes on the withdrawn amount.
Now, if I had just dumped that same amount of cash into SPY, and held for the same 30 years, I’d have $4.9m before taxes. Selling everything and paying taxes, will leave me with about $3.5m. Cash.
So, while on paper, my net worth is $4m/7.1m (depending on whether I live), in practice, I can really only access $3.2m, which is quite a bit less than just buying SPY.
You cannot eat net worth
The thing most people get confused by, is the number on their “balance sheet” indicating their net worth. But net worth isn’t the whole story. To put it bluntly, you cannot eat net worth. Having a net worth of $100m is completely useless unless you can liquidate that net worth to get actual cash, with which to actually buy stuff.
And that’s where it gets complicated — not all net worth are created equal. As we discussed in Zero sum game, it is very easy to manipulate numbers to make your net worth essentially say whatever you want. Heck, if you want, I will give you $10m — I have a piece of paper here, on which I’ll write “So-and-so has $10m… as long as they agree never to ever withdraw that money”. Congrats on being a multi-millionaire.
Another case where not all net worth are equal is taxes. Let’s say Alex bought 1,000 shares of a company that pays no dividend 20 years ago at $1 per share. That stock is now worth $1,000, so on paper, Alex has $1m. Compared to Blair who, literally, just has $1m sitting in the bank. Some may think that both Alex and Blair are equally rich. But are they really?
If Alex wants to buy anything, they will have to liquidate some of the shares, which then triggers capital gains taxes. Taking out the capital gains taxes will leave Alex with quite a bit less than $1m. Blair, on the other hand, has $1m completely free and clear.
Net worth is useless?
Not quite. Net worth is still useful, as long as you can liquidate it easily. What you are doing when you liquidate your assets (i.e.: net worth) is literally to create cash flow. Cash flow which can then be used to buy stuff you actually do need, like, you know, food.
So while net worth is weird and funky in all sorts of unintuitive ways, cash flow, particularly after tax cash flow, is fairly simple to understand — if you have $1,000 in after tax cash flow, spending more than $1,000 means you’ll become poorer, and spending less than $1,000 means you’ll become richer, over time. Simple as.
Like the story in Zero sum game, we need to always keep in mind the distinction between stock and flow. Net worth, being a stock metric, is always subject to the whims of the market. If the market decides that your assets are worth $500 instead of $1,000 today, well, you just lost half your net worth. But flow is stable — a dollar is a dollar is a dollar (1).
So, given a choice, I’d rather have a guaranteed $500k of cash flow every year (indexed to inflation), than $10m of assets that I cannot sell (also indexed to inflation) — If you have $500k of cash flow every year, you pretty much can ignore your net worth and still live a very comfortable life. But having a, say, unsellable diamond worth $10m is really only useful if you eat diamonds for breakfast. Or something.
Net worth vs cash flow
In reality, net worth and cash flow are tied. (Hopefully) nobody is dumb enough to put all their money into illiquid assets with no cash flow. Instead, most people invest in either liquid assets (stocks, bonds, etc.) or illiquid assets with cash flow (real estate, private businesses, etc.). So in most cases, having a higher net worth means a higher cash flow, and vice versa.
The thing to keep in mind is, again, “you cannot eat net worth”. It’s all fine and well to have a high net worth, but if you like eating, or having a roof over your head (2), you need to figure out the cash flow picture.
And then what?
All these tie back to 3 words I ask a lot when someone shows me their latest highly levered bets on various speculative assets — and then what?
In all of these cases, the person has money in some levered asset that, for whatever reasons, has done well recently. On paper, they are doing pretty well.
That’s great! But unless you think that asset will continue to do well (or at least maintain its value) up until the point you need cash in the future (20, 30, 40 years from now when you retire?), the thing you need to ask yourself is… and then what?
Are you going to sell and buy something with a stable cash flow?
Are you going to keep the money in that asset and pray that it’s not just a temporary spike and everything will just disappear tomorrow?
Are you going to sell and keep everything in cash?
Recall that speculation is a zero sum game. At some point, somebody will have to eat a loss if somebody else made a gain. Which of the 2 somebodies are you gonna be in the future?
Footnotes
- OK, not quite. Dollars (and all fiat currencies) tend to depreciate over time due to inflation. But that’s more of a long term thing compared to the short term issues we are discussing here.
- Admittedly this is anecdotal — I like to eat on a regular basis and have a roof over my head. You are, of course, free to pursue your own preferences.
Janky Thoughts 