When pursuing financial independence, net worth is often a key focus as it provides an overall snapshot of your finances and provides an easy way to track your progress.
However, things can get a bit complicated when the value of your assets change over time.
For example, as the value of real estate goes up, your house may be worth more. On paper, that means your net worth will likely increase. But does this improve your financial situation? Not necessarily.
If you're planning to downsize your home, you may come out ahead. But if you don't plan to sell and reduce your cost of living, you likely won't realize much of a benefit.
Because of this, we've always chosen to track two values for our net worth - the 'real value' and the 'book value'.
Real Value vs. Book Value
The 'real value' of our net worth is based on the actual value of our assets (less any taxes or fees we would need to pay if we sold them), and provides a snapshot of our current financial situation.
Essentially, it tells us how much money we would have if we sold all of our assets and paid off all of our debts. While this number is definitely important, it is not always the most meaningful.
For example, if your net worth grew at the same rate as inflation, it would increase each year, but your purchasing power wouldn't increase at all.
Current market conditions also have a direct effect on this number. This can create a great sense of accomplishment (or stress) over short term fluctuations that mean little to the long-term investor.
When markets were strong, our net worth would go up even if we didn't save a penny. And when markets took a hit, our net worth would plummet no matter how much we contributed.
While it is easy to say we'll ignore these fluctuations, this can be much more difficult in practice. Because of this, we decided to start tracking the 'book value' of our net worth as well.
The 'book value' of our net worth is based on what we paid for our assets, and tracking it allows us to see how much progress we're making each year as a direct result of our efforts.
For example, even though the value of our home has tripled on paper, the 'book value' of our net worth is still based on the original purchase price. The only gains we see each year are a result of paying down our mortgage principal.
The same goes for our investments - any increase in the 'book value' of our net worth is based solely on new contributions.
Staying Focused
Tracking our net worth this way keeps us focused on our goals. If we only monitored the 'real value' of our net worth, we likely wouldn't feel the same level of motivation to increase - or even maintain - our efforts when markets were strong.
And if markets took a hit, we'd feel devastated watching our net worth drop, potentially leading us to make emotional decisions about our long-term investments based on short-term trends.
By focusing our attention on the things we can control - such as how much we save and invest - we're able to remove some of the emotions that can reek havoc on even the most solid financial plan.
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