Someone much smarter than me once said, “What gets measured gets improved.”
This idea is one of the foundations of MBO, or management by objectives. MBO is taught in MBA programs world wide, and applied everywhere from Google, to Microsoft, and is even entering the nonprofit world at the Bill & Melinda Gates Foundation. Here’s why it works.
MBO consists of several features, starting with finding a common goal. Most of us would like to retire someday, some of us sooner than others, some of us would rather keep working. Regardless, everyone by the time we reach our golden years would rather not have to work for an income just to pay the bills. At that point we would rather work for pleasure, leaving something behind, or choose to play with their grand kids. How do you get there? You start with defining your goal. Ask the question, “Where do we want to go?” This gets you and your significant other on the same page and will help you decide for starters, should we spend our entire check every two weeks and live it up, or should we stock away a few bucks for the future? If you don’t have a goal for your financial future, what’s to stop you from cashing in for the now?.
Once you have your goal, the next step is to decide how you are going to get there. Are you already on the right path, or are you heading in the wrong direction all together? The first step in finding out is calculating your net worth. This isn’t anything complicated. You simply add up all your cash, retirement, assets, house, cars, valuables etc. and subtract any debts ie credit card balances, student loans, mortgages, money owed to friends of family. The first time you do this it may involve a little head scratching to put together a complete list of your assets and liabilities, but once you have this list it is easy to update each month. Which brings me to the second step.
Make no changes at all to your current spending patterns for a month, then at the end of that month calculate your net worth and see if it has changed at all from the month prior. Chances are it did, It isn’t important at this point whether it went up and down, but that you notice a change. This change could have been in your control or not. Things out of your control are the fluctuations of the stock market, or the value of your house. If a large percentage of your net worth is in your retirement account, then a small dip in the market can have a large impact on your net worth. You don’t need to worry about those, it will be hard not to, but trust me and focus on only what is in your circle of control.
As you continue to monitor your net worth month after month, you’ll begin to see how the small decisions you make impact your net worth. Let say you are like me at one point and thought it would be awesome to have a really cool car, for me it was a BMW 330ci. Each month you look up the car kelly blue book see that it is rapidly going down in value, and every couple of months you visit your friendly neighborhood mechanic and fork over another handful of cash for one of those expensive repair bills. You’ll eventually ask yourself the question, is this car or variable expense, in line with my long term goals. Maybe having such a huge chunk of cash tied up in something going down in value, and costing me so much to maintain, isn’t such a good idea after all.
On the other hand maybe you have been dutifully contributing to your company’s 401k and your own individual Roth IRA each month for years. You may have never known exactly what number you needed to end up at, or when you would want to become financially independent, buy you knew you wanted to get there someday. Knowing your net worth, as well as your spending rate will tell you how long it will take to get there and just what amount that is going to take. Here’s the good news, once your net worth = 25 x your spending rate, you are financially independent. Financially independent means that you no longer have to work for money, you can choose to work for your passion that pays less or nothing at all, in other words, you are no longer dependent on a job to provide for you financially. This comes from a 4% safe withdrawal rate from your retirement accounts, of which you will never touch the principal. Mr. Collins over at http://jlcollinsnh.com explains this much better than I can here. If would like to find out just how long it is going to take you to reach financial independence, you can play around with this cool compound interest calculator. Or just take a look at the chart below. Based upon the percent of your income you are able to save, assuming an 8% annual return on investment, and safe 4% annual withdrawal rate, it will show you how long you have until financial independence.
You should be able to see how paying attention to your net worth might make a difference down the road.