Money, and how to have more of them, have always been a popular topic in the financial domain. Whether the extensive coverage of the subject makes people take better decisions or not with their money, I don't know. I expect many of the ones who do their research and apply what they learn will do better than before, but that's not a guarantee. But being more informed never hurt anyone.
In today's post we will talk about terms like:
Let's delve into it.
Income as a Measure for Someone's Financial Well-Being
Most people look at income as the best measure of someone's financial well-being. And even more, salary is what matters to them since most people are employed and it is a facile way to reduce income only to this form of rhythmic payment for the work executed for the employer.
That's why, life as an employee is a constant pursue of increasing the income. The higher on the ladder one goes, the more diversified the types of income received, besides salary.
We can have here participation in the profit of the company, through bonuses. stock distribution, dividends, and other non-monetary benefits.
Income also comes from other investments you have placed, assets you rented out, royalties, interest, capital gains.
But income is a relatively poor way to measure someone's financial well-being, for more than one reason.
For one, if we are talking about salary or employee benefits, if the employee loses his or her job, those income sources are gone. There is no guarantee the employee will find an equally or better paid job, especially if the economic situation isn't great for the job market (kind of like it is these days, when many technology companies downsized and maybe good employees lost their jobs).
The second aspect refers to debt. Income doesn't tell us anything about someone's indebtedness.
Let's say Alice earns a 200k USD a year income. If she spends 250k USD a year, she spends money she doesn't produce, so she either has to sell some assets to cover for the difference or her debt will start accumulating quickly.
If Bob earns 50k USD a year but spends 40k a year, he always has a surplus of 10k USD every year which accumulates. He can save or invest those 10k USD yearly, but the idea is he earns 5 times less income per year than Alice and yet he is doing better than Alice financially because he spends less than he makes every year while she doesn't.
Net Worth as a Measure for Someone's Financial Well-Being
A better indicator for someone's financial well-being at a given time is the net worth.
While net worth doesn't say anything about the income sources and the spending habits, it is a capture in time of the situation of a person's assets and liabilities. By subtracting the total liabilities (debt) from the total assets (investments, cash on hand, real estate you rent out, etc.), you obtain the net worth.
Net worth is a measure of wealth. Income is not. As we have seen in the example with Alice and Bob, one can have a much higher income and still spend more. If you spend more than you earn, it's unlikely to build up any wealth.
Lifestyle Adjustments
So this is where the lifestyle plays a role. Many people have the focus of improving their lifestyle as soon as their income grows, perhaps even above their possibilities, sometimes as a result of peer pressure, instead of improving their wealth.
If the lifestyle isn't backed by an adequate net worth level, it has no backing if the income becomes insufficient. And income has a tendency to fluctuate from a level upward.
This is a very risky route to take because it can lead to someone becoming broke.
That's why the focus should be to grow the net worth first, and then maybe change your lifestyle later, if that's what you wish.
It is also true when someone receives an unexpected fortune and he or she is not ready for it. Instead of investing to create passive income streams, the first priority is to change the lifestyle, spending a good portion of the unexpected net worth and potentially adding to the liabilities instead of the assets, which will drain the remaining amounts quickly instead of building up or at least preserving wealth.
Income Necessary to Build Up Net Worth - Spending Habits Should Be Under Control
At first, income is necessary to build net worth. So, this is where Alice would have an advantage, because she has a higher income, but only if her spending would be lower. Otherwise, Bob would still build up his net worth quicker, if they both spend per year as in the example.
Keeping spending under control is as important as having good income sources.
Reducing expenses is a great way to have a better bottom line. If you haven't done it before, it is probably more effective than trying to increase income sources further to cover for the extra expenses.
Paying debt is something that swallows a lot of our money. That's why, one of the best way to cut expenses is to be debt-free.
It's important to have a budget and to check where is your money going to every month and if you can cut some of those costs.
Also, always go shopping with a list, and if possible, when you are not hungry.
There are many ways to cut the spending, but the most important one is to understand you have a problem and to be determined to fix it.
Conclusion
In the end, is building up net worth important? It depends on every person's objectives. It is practically a requirement if you want to become financially independent or if you want to become financially wealthy.
Maybe it's not as important if you live a minimalist lifestyle, and you take care not to go into debt and check your spending habits. More money come with more responsibilities if you don't want to lose them, that's why some people will prefer a simpler and possibly a happier life.