Monday, October 3, 2011
Book Review: The Millionaire Next Door
How wealthy are you? Do you have a high income? Do you have high debt? How many income sources do you have? What is your overall net worth? These questions and more are ones that I feel more inclined to ask people who talk about their financial situation after re-reading for about the tenth time Dr. Thomas J. Stanley’s best seller The Millionaire Next Door . I first read it a couple of years ago when I was in college. I re-read it after graduating and going on active duty in the Army. I constantly find myself referring back to it on my Kindle. For me it was a much different read once I was earning a full time salary than it was when I was making a little above minimum wage at a part time job in college. Once you are earning more money than you ever thought you would (for me any entry-level salary after graduation would have met this criteria) then learning how to properly manage it can become an addicting idea…and so can finding the quickest way to spend it! This blog is part of my effort to be the former instead of the latter. Where The Millionaire Next Door comes into play is its data-based emphasis on regarding net worth as a more relevant measure of “how well off you are” and its numerous examples of how the majority of American millionaires are self-made individuals who practice the simple concept of “living below your means.” This certainly isn’t a new book but I can guarantee the lessons within it will seem new to many readers!
So much has been said about our society that seems to get a guilty pleasure fix off of observing the hyper consumption of the young, beautiful, and ridiculously rich people we see on TV that to say even one more word seems like kicking a dead horse. So, since the horse is already dead, I will kick it again! This infinitesimally small part of the population, a group of people Dr. Stanley refers to as the “glittering rich” , is thankfully not representative of the American millionaire population. Read that again: star athletes, movie stars, and social debutantes are the exception, not the rule. Through numerous studies based on surveys of America’s affluent Dr. Stanley and co-author Dr. William Danko found that the typical American millionaire does not live in an enclave of concentrated wealth (think of the kind of neighborhood the protagonists of HBO’s “Entourage” lived in…that is not where you will find most millionaires), does not drive a Cadillac Escalade or Ferrarri, and does not own a 100-foot yacht or a private plane. In fact many live what you would probably consider to be the pretty normal life, although perhaps a little more on the frugal side, of a small businessmen (which is what many of the millionaires next door are).
Okay, now the preceding paragraph might not have completely messed with the archetype of a millionaire in your mind. Sure you knew that actors and star athletes pursue high consumption lifestyles beyond the dreams of most mortals, and thus you reasonably assumed that most millionaires lived a more scaled down version of such a life. Fair enough. But even then your conception would still be inaccurate. Why? Dr. Stanley found that millionaires next door not only do not spend their money like it is going out of style, but they also do not necessarily earn extremely large amounts of money each year either. He found many millionaires with a combined household of income of less than $100,000 a year! Since chances are that you fit into this income demographic as opposed to that of the glittering rich (I know I sure do) then you should probably focus your efforts on finding out how people with that kind of income can end up with a wealth figure with that many zeros on it.
Here is the first important take away from this book that I want you to keep in mind: your net worth is a better reflection of your wealth than your income. While you will find high income people with high net worth and low income people with low net worth just having a high income does not cause you to have a high net worth, just as having a low income does not cause you to have a low net worth. Unless you have a realistic plan for earning seven figures a year (kudos to you if that option is available!) you need to disassociate the mental relationship between income and net worth. Why? Because if you earn $1,000,000 a year but your net worth is -$10,000,000 due to debt then you are in serious financial trouble! Instead, do what Dr. Stanley does and think of your income as your “offense” and your ability to build your net worth (saving, investing, etc…) as your “defense.” When I played football (don’t get excited, it was junior high school) our defensive coordinator always said “offense sells tickets, defense wins games!” The same rule applies to wealth management: if you don’t defend well (build up your net worth) it doesn’t matter how good your offense is (how much income you bring in) because you are still going to end up on the losing side whether it is a football game or your financial health.
The second take away from The Millionaire Next Door are two phrases of Dr. Stanley’s describing how successful a person is at building their wealth: Prodigious Accumulators of Wealth (PAW) and Under Accumulators of Wealth (UAW). You can probably tell from the names which group is the better one to be in. Dr. Stanley’s metric for determining which group an individual belongs to is based on his copyrighted Stanley Wealth Equation. If you have a greater net worth than the equation predicts then you are a PAW and to be truly wealthy you should have twice that number.
Now Dr. Stanley says that this is simply the easiest to use equation for evaluating wealth and I have indeed seen a slightly more refined version in another of his books ( The Millionaire Mind ) and additionally there are some criticisms of it. Stanley himself provides some qualifications for its use at his blog. The main one is that the equation Age * (Annual Household Income – Income From Inheritance) * 10% = Expected Net Worth – Wealth From Inheritance overstates what level of wealth many younger workers should be at. This is because he found the typical millionaire to earn more than $80,000 a year and to be in their middle 50s. Remember though that this is just a metric and that he also refers to PAWs as being BAs (Balance Sheet Affulent). So if you are too young for the equation to work well for you take a look at your personal balance sheet: are you bleeding cash and barely making ends meet or are you pushing your earned income into investments that are driving your net worth upwards?
The final major takeaway from this book (and believe me, there are many more minor ones) is the emphasis on living below your means (also known as NOT keeping up with the Jones’). One anecdote I really liked from the book was that of a millionaire small businessman who came home and told his wife he had transferred more than $8 million worth of stock in his company to her…and she went right back to doing what she was doing: cutting out coupons from the newspaper! Living Below Your Means (LBYM) is a remarkably simple concept in theory but as many have found it is much harder in practice. The catch is not that it is necessarily difficult to LBYM, it is just that many people seem wired (again, financial psychology is an incredibly interesting subject) to be unable to do it or simply have not been shown how to do it in the first place. If you want to build your wealth it all starts with being able to spend less than you earn. Once you are able to break even you can start looking for ways to cut back a little more at which point you can save or invest the income that is left over. The more you cut back the faster you can grow your net worth. How far you cut back is of course an individual/family choice but it is going to require the acceptance of the fact that you are going to have to delay some of your gratification until a later date.
The true value of The Millionaire Next Door is that it is not a “get rich quick” book however I would argue that it is a more effective resource for showing people how to become millionaires than the sort of books that put that goal in their titles. More important than making specific investment choices is developing the proper financial mindset that is conducive to building wealth: once you have the proper mindset the efficient employment of your money will follow. Read this book and ask yourself where you stand, mentally as well as financially, in relation to the millionaires profiled inside of it. What do you need to do to get where they are?
1. NET WORTH IS MORE RELEVANT THAN INCOME
2. BE A PAW, NOT A UAW
3. LIVE BELOW YOUR MEANS
Dr. Stanley maintains a website and blog at http://www.thomasjstanley.com/
Purchase The Millionaire Next Door used or for your Kindle at Amazon.com
Related Post: Two Different Ways To Spend $4,000-$6,000