What do you own and what do you owe? To figure out where you stand financially, you need to know your net worth — and yet that number is surprisingly difficult to calculate. Your assets are more than just your home and your investments, while your liabilities extend beyond your mortgage and other debts. Drawing up a personal balance sheet listing your assets and liabilities? Here are three key items you ought to include:
If you’re under age 50 and gainfully employed, your most valuable asset is probably your human capital — your ability to pull in a paycheck. The Census Bureau estimates, based on a 2011 survey, that a college graduate who works full time for 40 years might have lifetime earnings of $2.4 million, while someone with a professional degree, such as a doctor or lawyer, might earn $4.2 million.
Your human capital should heavily influence how you handle your larger financial life. For instance, to protect your human capital, you likely need health, disability and life insurance. Suppose you go under the proverbial bus or, alternatively, go under the bus but survive. In either situation, the right insurance can help your family cope.
Early in your adult life, you might take on a heap of debt, including student loans, car loans and mortgages. Reckless? Arguably, it’s rational. By borrowing, you can purchase items you can’t currently afford, thus smoothing out your consumption over your lifetime. With any luck, you will have years of paychecks ahead of you, so you can service these debts and eventually retire debt-free.
Your human capital is also the rationale behind investing heavily in stocks when you’re younger. Think of your regular paycheck as akin to receiving interest from a bond. To diversify your big human capital “bond,” you might devote your portfolio mostly to stocks. But as you approach retirement and your last paycheck, you should shift maybe half your portfolio into bonds, so you have investment income to replace the lost income from your human capital.
Don’t have quite enough saved for retirement? You could always continue to make use of your human capital by working a few days a week. Imagine you can make $16,000 a year working part time in retirement. Based on the often-recommended 4% portfolio withdrawal rate, that part-time work is like having a nest egg that’s $400,000 larger.
When you add up the assets you have available to pay for retirement, Social Security should figure prominently. Boston College’s Center for Retirement Research calculates that, for the typical household approaching retirement age, the value of future Social Security benefits would be $287,200, equal to 49% of the household’s $582,100 total wealth.
For retirees, Social Security is like a huge position in bonds, one that generates income that climbs each year along with inflation. Also got a traditional employer pension? You may find that a substantial portion of your total net worth is allocated to assets that look an awful lot like bonds. That might give you the financial leeway to invest more heavily in stocks. The growth from those stocks could help you fend off the threat from inflation and make your later retirement years more comfortable.
Your liabilities include not just your debts, but all future financial obligations. For instance, for most of us, our largest financial obligation is paying for retirement. Indeed, we spend four decades in the workforce amassing enough financial capital so that one day we can live without the income from our human capital.
But while retirement may be our greatest financial liability, it isn’t the only one. Just had a child? Congratulations, your financial liabilities might have just jumped by more than $400,000. The Agriculture Department estimates it costs $241,080 in today’s dollars for a middle-class family to raise a child through age 17. Add the cost of a private college, and you’re likely looking at well over $400,000.
Maybe the grandparents will be willing to help with those college costs, so not all the money has to come out of your pocket. That highlights an important point: Family isn’t just a liability; it can also be an asset.
In fact, as you think about your financial safety net, you might include the help your family could provide. Sure, you don’t want to be constantly asking your parents or siblings for money. But if you fell on hard times economically, there’s a good chance they would help you out financially.
This article originally appeared on MarketWatch.com and is reprinted by permission from Marketwatch.com, ©2014 Dow Jones & Co. Inc. All rights reserved.