By David Trahair
Thomas J. Stanley and William D. Danko explain how rich people get rich in The Millionaire Next Door.
Most people dream of becoming millionaires. They want to live the life of luxury — vacationing on the French Riviera, driving a Lamborghini, wearing the latest Italian designer suits and drinking 50-year-old Chivas Regal. Many wealthy people can afford to live such a lifestyle because they have the money. For some it was easy — they inherited seven figures from their parents. Others built businesses that generate millions of dollars in profits every year. Others simply earn incredible amounts of money each year and can afford to do things such as shutting down the Grand Canal in Venice for their wedding.
The problem is that many people striving to become rich emulate the spending of the rich but not the behaviour that made them wealthy. These people never achieve wealth; in fact they often end up poor and burdened with debt.
One book that does an excellent job of explaining how real wealth is attained is The Millionaire Next Door: The Surprising Secrets of America’s Wealthy, by Thomas J. Stanley and William D. Danko. It was originally published in 1996 but the key messages it contains are more important today than ever because we have become a nation of spenders, and spenders rarely achieve financial independence.
The authors spent 20-plus years studying the wealthy. They started in upscale neighbourhoods, figuring that’s where wealthy people live. In time, they discovered something odd. Many people who live in large homes and drive luxury vehicles do not actually have much wealth. Conversely they found that many affluent people don’t live in upscale neighbourhoods.
That’s right — many people who “look” like millionaires are not. And the ones who are wealthy often don’t look the part.
The essential message is that wealth is not the same as income. A person who makes $500,000 a year and spends it all will not become rich. Wealth is what you accumulate, not what you spend.
Another interesting finding is that self-employed people make up two-thirds of the millionaire population, even though they make up only about 20% of workers in general. Why is that? Because many of them built businesses that grew in value without that growth being taxed along the way. You don’t have to tell any high-income earner that fighting the battle against taxes is the hardest part of trying to save and build wealth.
The authors also point out that self-employed people are familiar with bookkeeping because they have to track their business expenses. Many of them use the same technique to track their personal spending. This is one of the secrets the rich use to control their expenses — it’s difficult to control what you can’t see and most people do not bother to monitor their expenses.
The book concludes that many millionaires don’t earn huge incomes — they simply live below their means by spending less than they make, allowing them to put money away. That is why they often live in neighbourhoods with people who are worth a lot less. They could afford to live in more expensive areas, but they don’t so they can avoid the additional expenses. It’s not just the additional cost of a larger house — it’s more expensive to live in an upscale neighbourhood because there is tremendous pressure to also look the part. You need to pay for things such as the right car in the driveway, professional landscaping and suitable decorations during the holidays. Living in a middle-class area can save you a lot of dough because it’s cheaper to fit in.
The authors have an interesting formula to determine what your household net worth should be. Multiply your age times your realized pretax annual household income from all sources except inheritances and divide the result by 10. This, less any inherited wealth, is what your net worth should be.
What’s your number? If your net worth is double or more than what is expected, you are a prodigious accumulator of wealth. If your net worth is half or less than the number, you are an underaccumulator of wealth. Relating net worth to income makes more sense than just focusing on one arbitrary number such as $1-million net worth to determine who is wealthy.
The problem today is that many people are spending every penny they make. In fact many are spending more than they make, which is easy to do with credit cards and lines of credit. Reading this book might be what people need to turn the tide and start on the road to building wealth rather than sabotaging their chance of financial independence. If you know people in this category, buy them this book. It’s probably the best gift you could ever give them.
David Trahair, CPA, CA, is a speaker and author of five books related to personal financial issues, including his latest, Cash Cows, Pigs and Jackpots.