All of us have some experience with stepping on a scale and using our weight as a proxy for overall health. In much the same manner, it is useful to have a shortcut for checking on your personal wealth. We have a simple formula for just that purpose and we call it Total Economic Wealth. We have created a brief whiteboard video that explains the formula in detail.
Total Economic Wealth consists of four parts:
First, and perhaps the most overlooked, is Human Capital, the ability to produce and earn income. Your lifetime earnings capacity, particularly for skilled professionals and entrepreneurs, may dwarf every other component of your financial life.
Next, Financial Assets – this includes cash and liquid investments outside of retirement accounts. We often advise clients to build liquidity with mutual funds and similar holdings in addition to savings for retirement. This additional liquidity translates into flexibility as ongoing financial decisions are made.
Then, Retirement Assets – this category includes 401-k plans, IRA’s and other accounts designated for retirement. The tax deferral component alone makes retirement accounts attractive but a balance between these assets and other financial assets is important as you move towards retirement.
Finally, Real Estate – ownership of residential real estate (or commercial real estate held for investment) is also an important aspect of Total Economic Wealth. Because real estate is illiquid (and therefore can’t be relied upon for retirement or other more immediate withdrawals), it should usually not be the foundation for building wealth.
When added together, these four parts (Human Capital + Financial Assets + Retirement Assets + Real Estate) provide a reasonable approximation of your total wealth.
Inverting the Pyramid
When you are young, the first part of the equation, human capital is likely larger than any other component. Your lifetime ability to earn money and save money is substantial. At this stage, the financial, retirement and real estate assets are usually relatively small. As the years progress, these parts of the equation should grow larger while human capital diminishes. Our role, in partnership with you, is to help protect your Total Economic Wealth and keep you on track. Ready for a real conversation?