Feb
26
Networth Vs. Passive Income
February 26, 2007 | 1 Comment
One of the first things any person should learn is to track their own networth. Many people discover that when they subtract the sum of all their debts from the sum of all their assets, they end up in negative numbers. By just calculating this value many people end up changing their habits and lifestyle completely: something that will benefit them down the road. Those whom bad habits are not changed with the first networth calculation, I invite them to keep track of it over time. Chart it like I do. And watch it, for it should be moving higher (lower negative numbers if negative). A networth moving in the positive direction means a life moving into a positive direction.However, once debt issues are solved I find another number of greater importance than networth. This number is passive income: money for which the owner didn’t had to work. This is dividends, royalties, rent income, interests above the inflation and such. It is the product of the invested capital but not necessarily the growth of it.
The reason I like to track it with even more fervor than networth is because networth can be deceiving sometimes, as any number may be. On a bad market day your networth may go down if you are heavily invested in stocks, and your networth may go down on a housing market slowdown if you are heavily invested in real estate. Also, many of us include the primary residence on the networth (as it is something we can sell and move to a less expensive place once we retire, like many baby boomers are doing now). When the networth includes the primary residence it reflects your capability to retire and puts your mortgage in context with the actual house price, but it skews the numbers a bit, as you recognize that in order to retire you have to lower your living standards a bit: that is where passive income comes in. (Note: I never include personal property like furniture, clothing and electronics in the networth: for me those are short lived articles of little resale value. Some jewelry can’t be included in networth either: I would not be taking back my wife’s engagement ring to invest such money.)
Even if your networth goes up or down temporarily, you may be approaching financial freedom readiness with an increasing passive income. It is just another proof that you are moving in the right direction. Although it is true that in a retirement or financial freedom situation you can eat up your capital, it is a lot better to eat up into passive income, for it renews itself year after year keeping more capital for later.
But don’t be fanatical about it. Don’t try to maximize passive income, just watch it grow and move in the right direction. For if you try to maximize it you may be loosing into the greatest capital growth opportunities. Just now and then add some passive revenue generating assets into your investments. I set my own goals to add a few thousand yearly dollars to the total amount of yearly passive income every calendar year.
Note: Another good exercise: track passive expenses are the opposite of passive income: interest payments and subscriptions for example. You can watch them and compare them to passive inform and get a good indication of how ready you are for financial freedom.
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Though I keep track of “alternative income” instead of passive income. The difference is that income from my blog (my hobby) is definitely not passive. Yet, I feel it should count since it doesn’t come from my 9-5 job.
I also keep track of passive expenses, which I call “necessary expenses.” I add up things like rent, car payments, gas, food, cable, Internet access… pretty much any expense that I pay each month.
I subtract that alternative income from my necessary expenses to come up with a total of how how far away from one level of financial freedom. Obviously there are other costs each month and things like that, but I will have some kind of party when that income passes expenses. At that point, if I lose my job, my “burn rate” will be so tiny that I won’t be rushed into taking a job because I need it to get by.
You can see all this in a tiny box in the top right of my page. I keep track of both of mine on my homepage.