I resisted reading The Millionaire Next Door for a long time, because the title led me to the assumption that it was a get-rich-quick tome.  I was very wrong about that, and I was disappointed that I waited so long.  I’ve now read the book twice.  To be precise, on both cases I listened to an audio version that I purchase from Audible.com, a favorite service of mine.  Far from being a book in the genre of Rich Dad, Poor Dad and its ilk, the book, written by Thomas J. Stanley, Ph.D. and William D. Danko, Ph.D, grew out of hard research they had performed about the affluent in America.

I should point out that a premise of the book seems to be that achieving millionaire status is an important goal and worthy of focus.  Not all readers would deem that a worthy goal.  Nonetheless, there are lessons in this book about financial comfort and independence that are universally applicable.  The impact of stress on our immune systems and overall health is undeniable.  An Ohio State University study has found that money-related stress had a stronger link to depression symptoms among breast cancer patients than even stress related to the recent death or illness of a loved one!  Living within our means is a sure way to reduce our stress, and that is the underlying message that I took from this book.

Before I go any further, I should stress that the book was originally published in 1996, and one million dollars went a bit further then.  We’ve had three significant shocks to the financial system in the interim!  Alas, the lessons still apply, even if some of the statistics are outdated.  In fact, applying the concepts in this book would have saved a lot of people some pain over the last couple of years.

There are a few fundamental concepts that I think are important.  Beyond that, I highly recommend getting this book (preferably at the library) and reading it closely.

The basic thrust of the book is that the average millionaire in the United States probably does not fit the profile that most people imagine when they think of millionaires.

What is wealthy?

The authors appropriately define wealth in terms of net worth rather than the number of expensive vehicles in the garage or the size of the house.  In 1996, they used a crude, absolute threshold of $1 million in net worth to be considered “wealthy”.  In today’s dollars, that translates to something close to $1.4 million.  However, they define a much more informative measure that describes how wealthy a person should be given his or her age and income level.  The formula is as follows:

Expected wealth = Age multiplied by pretax annual income (from all sources except inheritance), divided by ten

This is a much more useful measure, as it factors in standard of living.  To a significant degree, this metric captures whether or not an individual is living within his or her means.

PAWs and UAWs

The authors highlight two categories of savers:  Prodigious Accumulators of Wealth and Under Accumulators of Wealth, or PAWs and UAWs.  Accumulating wealth at a rate greater than at least 75% of the population qualifies an individual as a PAW, while doing so at a pace that is less than 25% puts one in the UAW group.  To make this more universal, they offer a simpler rule:  your net worth should be twice the level of expected wealth to be a PAW, while less than half of the expected net worth would place you in the UAW range.  So, if you’re 35 and making $100,000 per year, your expected wealth is $350,000.  If your net worth exceeds $700,000, you’re a PAW.  If it is less than $175,000, you fall into the UAW category.

This highlights another distinction called out by the authors:  balance sheet affluent vs. income statement affluent.  Examples abound of doctors and lawyers making over $500,000 per year while having little in the way of sustainable assets to show for it.  More impressive are the examples of individuals who make less than $100,000 per year in earned income, but can never work another day and be comfortable.  It’s all about living within your means.  (In fairness, many examples of the latter case lived well below their means).

They earned it

Another interesting point was that 80% of the wealthy in this study were first-generation millionaires.  They did not inherit wealth.  However, the country clubs of America are littered with inheritors who are quickly blowing through the cash their parents have left them, with no means of replenishing it.

That brings us to the concept of economic outpatient care.  This was much more of a black-and-white issue for me before I had children, but the statistics are still very powerful.  Adult children who had received any kind of financial assistance from their parents suffered for it.  The authors “found that the giving of such gifts is the single most significant factor that explains lack of productivity among the adult children of the affluent."  In eight of ten occupations held by children of the affluent, households that received regular gifts had lower net worth than those who did not.  Overall, such individuals had an average of 81% of the wealth of their non-receiving counterparts, although this was skewed upward by teachers, who apparently used the gifts they received to build additional wealth.  Receivers of EOC invest less and use more credit.  They come to depend on the gifts as supplements to their income, and proceed to live at a higher level.

The book offers a lot of data that is very eye-opening, and it clearly demonstrates that the average wealthy individual is not driving around in a Ferrari.  However, the takeaway ideas are pretty straightforward and common sensical.  That doesn't mean they're easy to apply, though.  Reading this book really reinforces that common sense.  Similarly, Thomas J. Stanley's latest book - Stop Acting Rich - doesn't really present radical new concepts beyond those of The Millionaire Next Door.  It does, however, reinforce the concepts in much the same way as its predecessor.  It, too, is worth reading several times.

I just read a somewhat provocative article by Liz Pulliam Weston entitled 4 Reasons we get ripped off, and I think you should read it, too.  It’s concise, but points to some actions that consumers can take to avoid falling prey to those who would take advantage of weakness, legal or illegal.

I’ll summarize the reasons here and provide my perspective.

Americans stink at math

No argument here, but this is pretty easily fixable.  The Department of Labor states that 58% of American adults cannot add 60 cents to $1.95 and calculate a 10% tip.  That is startling.  If you fall into this category, I recommend taking a remedial math class.  My guess is that elementary school students would fare a bit better in this survey, because they’re doing these kinds of calculations more frequently.

We don't recognize sociopaths

This reason is kind of depressing and little bit scary, but undoubtedly true.  In fact, I am not sure it is only  sociopaths about whom we should be concerned.  An even bigger concern for me is the number of salespeople who do not act in the best interest of their customers but feel that is the standard way of doing business.  Sometimes the lines are not so clear.  When you buy a car, the salesperson receives a commission, and it’s entirely appropriate for her to be compensated for her effort.  How much compensation is okay?  That’s a blurry line, but too often the answer is “as much as possible”.

In my business, the norm is probably to not act in the best interest of the client.  Most financial “advisors” are simply salespeople who are not obligated to act in their clients' best interests.  In this case, my recommendation – self-serving though it may seem – is to work with an advisor who is a fiduciary and thus is legally required to act in the best interest of the client.

In general, try to understand how a salesperson is compensated and what his or her incentives are.  Do they make more money pushing certain products over others?  Is it obvious what your total cost will be?  If any of this is unclear, ask!  Furthermore, before making a purchase of consequence, develop a plan and stick to it, including a budget for the purchase.  It is much harder to be persuaded to go beyond what makes sense when you’ve established firm boundaries.

Bait-and-switch capitalism is now the norm

This is definitely a problem.  I think it’s important to try to find alternatives whenever possible, including cancelling your service in favor of a more transparent one.  Most importantly, ask about the total cost up front.  You still may get a lie in response (back to the sociopath concern), but at least that will become obvious pretty quickly after the fact and you can take steps to rectify the situation then.

Half the police force has disappeared

There is a lot of debate in our society about the appropriateness of new legislation and the size of government. Certainly, the legislative framework in several areas is imperfect. Nonetheless, I think effective enforcement is a more important consideration at this stage.

A recent article in the Personal Finance section of the Wall Street Journal talks about the math of clipping coupons.  I think there are a couple of of important points here.  One is that a knowledgeable (and aggressive) consumer can save a lot more money than is probably obvious to most people, because most people don't walk through the calculation of how much they're actually saving.

The second critical point is that savings are rarely considered from an after-tax perspective.  Despite Ben Franklin's assertion, a penny saved in this case is really not the equivalent of a penny earned.  Setting aside the peculiarities of our income tax code for the sake of simplicity, consumers in the 33% tax bracket must actually earn an additional 50 cents for every dollar they save.  Saving $20 at the grocery store each week really allows you to forego an additonal $30 in earnings that would have been required to spend that $20.  In other words, consumes tend to undervalue the impact of the amount they're saving.

Interestingly, more often than not my wife and I find that the coupons we're prepared to use at the grocery store do not save us enough to match the cost of the equivalent store-brand product, so we do not end up using the coupons.  Nonetheless, the article raises valid arguments about how to go about determining if a "frugality initiative" makes sense for you.

 

 

 

Recently, I discovered that the author of one of my favorite books has finally launched a blog.  My intent has been to write a book review of The Millionaire Next Door, and introduce the blog of Thomas J. Stanley along with that.  Alas, the review has taken a bit longer than planned, so until I release that blockbuster post, check out what Thomas Stanley has to say.  His research has had a profound affect on my view of the way people interact with money, and particularly on the importance of living within your means.