Depreciating assets will hurt your wealth

Depreciation

Depreciation happens when an asset loses value over time. This is the case for many assets. It means that if you buy an asset at 10’000 CHF, the price will not remain the same over time.

Some assets are depreciating very quickly, while others are depreciating slowly. It all depends on which asset we are talking about. And the depreciation is not always liner either. For instance, a car will lose a large part of its value directly after you buy it. And then, it will lose value at a reduced pace. Many assets are impossible to sell at the same price at which you bought them.

It is crucial to take depreciation into account when you consider the value of your assets. This is especially important when you compute your net worth. Many people are doing themselves a disfavor by considering the price of assets in their net worth without accounting for depreciation. It means that they have a very bad estimation of their net worth.

For instance, many people are terrible at estimating the price of their car. They think it is worth the same as when they bought it. I am going to use the example of cars often in this article. They are just an excellent example and people are doing big mistakes when they purchase cars. And it is the same for many assets, as we will see below.

You should not ignore depreciation. It is important to take depreciation into account in your financial decisions.

In this article, I will focus on personal items that depreciate and their impact on wealth. Depreciation in accounting is a whole different matter, and I will not delve into it. Depreciation in personal finance is already a big deal.

Depreciating assets

The vast majority of assets are depreciating assets. In fact, there are only a few assets that do not depreciate. What is important is that some assets depreciate much faster than others.

There is no rule for computing the depreciation of assets. Generally speaking, the value of an item depreciates inversely to the time it can be used. For instance, if you can use an asset for 10 years, it should depreciate by at least 10% per year.

Now, more factors play a role in the depreciation of assets:

1. The profit of the shop. If the shop takes a 20% profit on something, this is generally lost as soon as you exit the shop.
2. The value of the brand. Some people are prepared to pay more for some brands (German cars, Apple phones…).
3. The speed of obsolescence of the items. Some items see a new generation every few years. This makes the previous generation less valuable.

The most well-known depreciating asset is a car. Cars are well-known for losing a lot of value very quickly in the first year. Generally, you can consider that a new car will lose 10% of its value as soon as you drive it off the garage. And during the first year, the car will have lost about 20% of its value. After that, cars are generally losing between 10% and 20% of their value each year.

Of course, in practice, it is more complicated than that. Some brands are losing value faster than others. And some brands are known to conserve value better than others. However, a car will always depreciate.

Jewelry items can lose a lot of value very quickly as well. Many people are horrified when they find out that their jewelry’s value is almost nothing if they were to sell it. When you buy gold jewelry, for instance, as soon as you buy them, they are only worth the gold there is. The gold in jewelry will retain its value. But you will have lost all the value the jeweler put into it. If you were to melt a gold ring, it would still be worth the same thing at resale. Many jewelry pieces will lose more than half of their value directly when you go out of the store.

Again, there are some exceptions, like antique jewelry or unique pieces. But most jewelry is going to lose a lot of value. And it is the same with diamonds and other precious stones. A diamond ring will have lost a ton of value directly after you bought it unless the diamond is huge. The resale value of a small diamond is very low. A diamond ring can lose as much as 90% of its value directly after you buy it!

Clothes are equally losing value terribly fast. Specially made dresses like wedding dresses or tailored suits are no exception. You are very unlikely to sell it for more than a fourth of its value. For instance, we could resell Mrs. The Poor Swiss wedding dress for 25% of its value, and we were already quite happy about it. A good leather jacket could keep some value for a few years, but that is about it.

Smartphones are no exception to the rule. As soon as the next version of the phone is out (one year generally), you will have lost about 50% of its value. And after a few years, many smartphones will not be worth more than 10% or 20% of their original value. Apple phones are known to be the best at keeping their value. But it does not mean they are conserving their value. They are still losing value over time, just slower than other phones. And you are paying a premium to buy them.

Computers and electronics are also depreciating quite quickly in the first years. For instance, as soon as a new generation of graphics card hits the market, the previous generation will lose a big part of their money. Television, home cinemas, and home appliances fall into the same basket. Some brands will depreciate less (Miele washing machines, for instance).

Some items will lose all their value almost instantly. Most clothes are almost worthless as soon as you wore them. Books will also lose most of their value (80% at least) but will not change much after that.

As you can see, a lot of assets are subject to depreciation. And assets are depreciating very differently. But This does not mean that you should never buy a depreciating asset. In fact, it is pretty much impossible to avoid all depreciating assets. Many depreciating assets are necessary. If you need a car, buy a car, but be aware of the importance of depreciation.

How to account for depreciation in the net worth?

Now that you know about depreciating assets, how do you handle them in your net worth?

I would actually recommend to ignore most depreciating assets from your net worth. That way, you do not have to account for depreciation. You consider their value to be zero. And if you manage to sell them at some point, you will consider that as an earning and be happy about it.

Now, if you have some significant depreciating assets like a luxury car, you may want to include it in your net worth. But then, you must update its value on your net worth each year! And it is essential as well that you take the correct value into account. As mentioned before, a car will lose around 10% of its direction after you bought it. So, do not start with the full value of your car in your net worth. If you are doing so, you are lying to yourself and painting an invalid picture of your wealth.

Another thing I recommend is to ignore most of your small assets from your net worth. For instance, I would not put any jewelry pieces into net worth. The only exception is if you have an antique piece of jewelry or something like the Crown Jewels. But in that case, you are unlikely to need my blog! And you should not account for something you never intend to sell.

Personally, I do not account for the value of my car. I intend to drive it as long as possible, and I expect its value to be zero when I will change it. So, it would simply be too much trouble for me to check out for the value each year.

Actually, we do not account for any non-liquid assets except for our future house in our net worth. We have some assets that will be worth money if we ever sell them. But I do not want to keep updating their value every few years. It is much simpler to ignore their value.

If you want more details, I have a guide on computing your net worth. Your net worth is a good representation of your wealth.

Never borrow money to buy a depreciating asset

If you buy a depreciating asset, you are adding to your net worth. But the value it is adding will depreciate over time and go down to zero after some time.

The worst possible thing you can do for your net worth is borrow money to buy a depreciating asset! It means you are paying interest each month for losing money every month due to depreciation! You are not contributing to your net worth. You are depleting your net worth!

The car is once again, the best example of this terrible decision. Many people buy their car in leasing or with a car loan. It is bad for several reasons. First, the value of the car depreciates very quickly. So, let’s say you take a 50K USD 5-year loan to buy your car. At this point, your net worth has not changed because the initial value of the car is compensating for the value of the loan.

After one year, your car has lost 10K USD (20%) in value and is only worth 40K USD. So, your net worth has lost 10K in one year. On top of that, you still have a loan worth 40K, and you had to pay 11.5K (20% amortization + 3% interest)  for that loan. So, you paid 11.5K in a year for a zero-contribution to your net worth. You are paying money to lose money!

But cars are not the only example. The value of a home appliance or a home electronics will very quickly go down to zero. So, buying them with borrowed money makes zero financial sense.

The problem with that is that we live in a society that encourages borrowing money for buying depreciating assets. Leasing cars and expensive appliances is common in many countries in the world. People want the latest things to give off the illusion of wealth. But it is no more than an illusion. Most people in that situation are not wealthy, and many of them have a negative net worth.

It is important to realize this. Borrowed money should only be used for buying assets that appreciate over time. If you want to increase your wealth (your net worth) over time, you should be very careful about that advice.

How to take advantage of depreciation?

Not everything is dark with depreciation. You can take advantage of depreciation.

Since you know that depreciating assets are losing money quickly, you should not buy new depreciating assets. Most depreciating assets can be bought second-hand.

Again, cars are an excellent example (sorry!). If you buy a good brand like an Audi, you can avoid taking the hit for a large part of the deprecating by buying a good used Audi car. Let other people pay the largest depreciation and limit the impact on your wealth.

If you consider buying expensive pieces of furniture or home appliances, it may be an excellent opportunity for some second-hand shopping! And some items can be used forever while losing value quickly. For instance, books are great to buy used. If you take care of them, you will keep them your entire life. And you can buy them used at a fraction of their new prices.

The main way to take advantage of depreciation is to let other people pay for depreciation and buy second-hand items.

Appreciating assets

The contrary of a depreciating asset is an appreciating asset. Such an asset gains value over time.

These assets are much better for your wealth since they will increase the value of your net worth without you having to put more money into it. It is much better to own appreciating assets than to own depreciating assets.

The best example of an appreciating asset is a share of the stock market. Not all stock will appreciate over time, but it should appreciate it on average if you buy shares of a broad index.

Another example is real estate. Now, it is a bit different because not all assets will appreciate equally. Also, you need to maintain a property for it to appreciate over time. Without any maintenance, a real estate property will end up losing value over time. So, it is not free appreciation, but still an interesting appreciation.

The case of precious metals is quite difficult. On average, gold will increase in value. However, there can be periods where the value will stagnate. For instance, between 1980 and 2007, gold did not gain any value. But the value of gold increased six times between 2001 and 2011. You need to keep this in mind if you want to invest in gold.

Overall, you are much better off buying appreciating assets than buying depreciating. And you can even use leverage for buying appreciating assets for increasing your profits on appreciating assets. But you should never use leverage for depreciating assets. And you should always be careful with leverage.

Conclusion

It is very important to consider depreciation when you are considering buying assets. If you want to have a correct picture of your wealth, you need to estimate properly depreciating assets in your net worth.

For your net worth, I would recommend ignoring depreciating assets from your net worth. It is much easier and paints a more accurate picture of your wealth. Otherwise, you will have to update the value of these assets every year.

There is one more important thing: never borrow money to buy a depreciating asset! If you want to increase your wealth, you need to be careful about that!

If you want to know your wealth, the easiest way is to compute your personal net worth.

What depreciating assets do you own?