Nine Lessons in Wealth-Building from The Millionaire Next Door

Published on - February 9th, 2011 (by Robert Brokamp) 95 Comments

Tweet This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fools Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks. Want to become a millionaire? Then perhaps you should start by studying the behaviors of people who have done it. But dont worry you dont need to stop the next Mercedes you see and ask the driver intrusive questions, because two authors have done all the work for you. One of their findings: Most millionaires dont drive a Mercedes. Check out the lists of the best financial books of all time, and youre bound to find several that include The Millionaire Next Door: Surprising Secrets of Americas Wealthy. Written in 1996 by marketing professors William Danko and Thomas Stanley, its main premise is that people who look rich may not actually be rich; they overspend often on symbols of wealth but actually have modest portfolios and, sometimes, big debts. On the other hand, actual millionaires tend to live in middle-income neighborhoods, drive economical cars, wear simple watches, and buy suits off the rack. Youve likely heard of the book. You may be familiar with the premise. Perhaps you even read it way back when. But if you read it again as I recently have youll be reminded of some of true gems of wisdom Danko and Stanley gleaned from their thousands of surveys of millionaires.

To give you a taste, this post will highlight some of the timeless along with the lesserknown lessons of The Millionaire Next Door as well as Stanleys 2009 book, Stop Acting Richand Start Living Like a Real Millionaire. (A future post will feature my interview with Dr. Stanley.) Lesson #1: Income Does Not Equal Wealth Yes, higher-income households tend to have more wealth than lower- and middle-income households. But the size of a paycheck explains only approximately 30% of the variation of wealth among households. What really matters is how much of the income is invested. On average, millionaires invest nearly 20% of their income. Danko and Stanley offer a formula for determining whether you have a net worth that is commensurate with your income: Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by 10. This, less any inherited wealth, is what your net worth should be. The authors rightly call it a simple rule of thumb; a more thorough analysis would look at lifetime income, not just the most recent year. Plus, it strikes me that its more accurate for people who are at least a couple of decades into their careers. Its not realistic, for example, to think a 25-year-old who makes $30,000 would have accumulated $75,000 (25 x 30,000 10). However, for those in their mid-40s and later to meet this metric, they would have needed to save 10% to 15% of their incomes throughout their careers, or started later but saved 20% to 25% of their incomes. Thats not common, but also not impossible. The formula also helps in sorting out the millionaires-to-be and the millionaire-wannabes. Those in the top quartile of wealth accumulation are prodigious accumulators of wealth (PAWs), according to Danko and Stanley. Those in the bottom quartile are under accumulators of wealth (UAWs). Note: We actually discussed this benchmark here at Get Rich Slowly at the end of December. Many readers found the formula flawed for their circumstances. Lesson #2: Work That Budget The majority of millionaires have a budget. Of those who dont, they have what the authors called an artificial economic environment of scarcity, more commonly known as pay yourself first. In other words, they invest a good chunk of their income before they can spend any of it. As for those who do budget and plan out their expenses for the coming year, no, they dont enjoy it any more than the rest of us. But they appreciate the payoff, as well as fear the consequences of not doing it. As the authors wrote, Its much easier to budget if you visualize the long-term benefits of this task.

Lesson #3: Know Where Your Dough Doth Go Similar to the previous point, almost two-thirds of millionaires can answer yes to this question: Do you know how much your family spends each year for food, clothing, and shelter? In contrast, only 35% of high-income non-millionaires answered yes to this question. Millionaires are more likely to track their spending. Lesson #4: Know Where You Want Your Dough to Go Another two-thirds of millionaires answered in the affirmative to this question: Do you have a clearly defined set of daily, weekly, monthly, annual, and lifetime goals? One example: a woman who wants to have $5 million by the age of 65, at which point shell retire. At the time of the books publication, she had already reached millionaire status on an annual income of $90,000. As for those who answered no to the question, many of them are retired and have already reached their goal of financial independence. Lesson #5: Time Is Money All this budgeting and goaling takes time, but millionaires are willing to spend it. Prodigious accumulators of wealth spend nearly twice as many hours per month planning their investments as under accumulators of wealth. The majority of PAWs agreed with the following statements, while the majority of UAWs did not:

I spend a lot of time planning my financial future. Usually, I have sufficient time to handle my investments properly. When it comes to the allocation of my time, I place the management of my assets before my other activities.

You dont have to earn a big six-figure salary for planning to pay off. In a survey of 854 middle-income workers, Danko and Stanley found a strong positive correlation between investment planning and wealth accumulation. This extra planning doesnt just happen. According to the authors, Most PAWs have a regimented planning schedule. Each week, each month, each year, they plan their investments. Lesson #6: Love the Home Youre With Your choice of home and how often you choose a new one will determine your ability to accumulate wealth. According to The Millionaire Next Door, that wealthy family has been next door for quite a while. Half of millionaires have lived in the same house for more than 20 years. In Stop Acting Rich, Thomas Stanley digs deeper into how your address affects your spending, writing: Nothing has a greater impact on your wealth and your consumption than your choices of house and neighborhood. If you live in a high-price home in an exclusive community, you will spend more than you should and your ability to save and build wealth will be compromised. [P]eople who live in million-dollar homes are not millionaires. They may be high-income producers but, by trying to emulate glittering rich millionaires, they are living a treadmill existence.

He cites several statistics to back this up, including:

Ninety percent of millionaires live in homes valued below $1 million; 28.3% live in homes valued at $300,000 or less. On average, millionaires have a mortgage that is less than one-third of the value of their homes. If you really want to reduce your housing bill, join the 67,000 millionaires who live in mobile homes.

If youre looking to buy a home, Stanley provides this advice: The market value of the home you purchase should be less than three times your households total annual realized income. Note: J.D.s real millionaire next door has been in the same house for fifty years. Lesson #7: Love the Spouse Youre With The majority of wealthy people are married and stay married to the same person. Of course, marriage shouldnt be just about money. Were sure that 24-year-old Crystal Harris has other reasons for being engaged to 84-year-old Hugh Hefner; perhaps she loves his pipe. But several studies have shown that people who are married accumulate more wealth than those who are single or divorced. However, its important to marry someone with the right financial habits. In the majority of millionaire households studied by Danko and Stanley, the husband is the main breadwinner and tends to be frugal, but the wife is even more frugal. As they wrote, A couple cannot accumulate wealth if one of its members is a hyperconsumer. Lesson #8: Dont Drive Away Your Wealth The majority of millionaires own their cars, rather than lease. Approximately a quarter have a current-year model, but another quarter drive a car that is four years old or older. More than a third tend to buy used vehicles. What is the most popular car maker among millionaires, according to Stop Acting Rich? Toyota. So whos driving all those BMWs and Mercedes-es? Not millionaires. Eighty-six percent of prestige/luxury cars are bought by non-millionaires. In fact, Stanley writes that one in three people who traded in their old car for a new one were upside down and owed more on the trade-in than its market value. Its tough to get wealthy doing stuff like that. Lesson #9: The Rich Are Different Theyre Happier At this point, you might be wondering whether all this living below your means is worth it. Sure, millionaires having bigger portfolios but are they happier? Danko and Stanleys research indicates that they are. According to their research, Financially independent people are happier than those in their same income/age cohort who are not financially secure.

First of all, PAWs worry less than UAWs. Theres a peace of mind that comes from living below your means and having money in the bank. But they also dont expect status purchases to improve their happiness, because evidence shows it doesnt happen. Among the people surveyed, those who drive a BMW and wear a Rolex are not happier than those who drive a Honda and wear a Timex. The Double-sided Benefits of Living Below Your Means After reading these books, it occurred to me that there are actually two benefits of learning to live on much less than your paycheck.

The first, of course, is that you can save more. But secondly, it also means that you ultimately need to save less.

Permit me to demonstrate. Someone who makes $50,000 but lives on just $40,000 can contribute $10,000 a year to her nest egg, and can retire when that nest egg is big enough to generate along with Social Security and other benefits $40,000 a year. However, someone who makes $50,000 but spends, say, $48,000 is contributing just $2,000 to a portfolio that must eventually help provide $48,000 a year in retirement. In other words, shes saving less yet needs to accumulate more. Thus, when it comes to retirement planning, adopting the lifestyle of the millionaire next door means you can save more toward a lower-priced goal. Thats a formula that can help even non-millionaires achieve their retirement goals.