39 Become (and stay!) a millionaire

Here’s an extraordinary book which tells you how America’s millionaires came to be so. Stanley and Denko (both PhDs) in their book The Millionaire Next Door. The Surprising Secrets of America’s Wealthy, demolish many myths or notions about the wealthy. Almost every line has a nugget of information, based on studies and surveys, that show how most of them accumulated their wealth the hard way: by working hard and steadily, minimizing expenditure, and saving and investing assiduously. The majority are self-made millionaires in their own lifetime, not inheritors of fortunes. The secret is that they don’t live like millionaires: they live in ordinary neighborhoods, drive ordinary cars, they maximize their assets (investments, nest-egg, cumulative capital), not their consumption expenditure, they are “compulsive” savers and investors.

The difference lies between those who have a solid net worth (more than 1 million in the 1995 study here) and those who have high consumption, but little in the way of appreciating assets (apart from luxury possessions and imported motor cars which rapidly lose value). The difference doesn’t lie in the income, so much as in what they do with the income. Wealthy families are generally very frugal: they shop in ordinary outlets, they live in modest houses in ordinary neighborhoods, and live a modest life. Most of them, for example, have ordinary cars rather than imported luxury models; many of them in fact don’t even buy brand new, preferring to get a used car that has already suffered its initial depreciation but is still in perfect  condition.

The authors also supply a sort of thumb rule of how much net worth one should have to be called wealthy: that is to multiply the realized annual pre-tax income by one-tenth of the age (age divided by ten). Thus it is not just the accumulated wealth (1 million and up), but also whether the accumulated investments are commensurate with annual incomes according to this thumb rule. I am not quite convinced by this formula: for a person near retirement, say 60 years, this works out to just 6 times annual income, whereas at 8% average return on assets, one would need at least 12.5 times the previous income to retire without suffering a fall in income. However, I guess if post-retirement requirements are only 60% of previous income level (as has been suggested by certain authors, see previous post 36), this may make sense. The authors also report that the favoured instruments for the investments are those assets that can be expected to appreciate in value, such as company stock, real estate, share of businesses, etc. Further, those with twice this expected level are termed prodigious accumulators of wealth, while those with less are under-accumulators.

The next question is, how do they accumulate these levels of assets? Here the crucial factor is not so much the incomes, but how much of it they are able to save every year; the authors suggest a thumb rule of 15% minimum saving and investment from the annual realized incomes before tax (I would suggest aiming for a somewhat higher 25% minimum especially in the early years of a career, see post 36). Two families earning the same level may be totally different in their accumulated savings; indeed, the standard of living or kind of lifestyle is not a good indicator of how wealthy a family has. A flashy lifestyle (costly houses and flashy cars replaced frequently, foreign vacations, private schools, club memberships, credit cards, costly clothes and other purchases) are usually inversely related to wealth. Self-made entrepreneurs are prone to living frugal lives, and build up high savings and investments; professionals like doctors and attorneys, who earn high incomes, also consume and spend on a more lavish scale, partly because they have to keep up appearances, and are therefore not that wealthy. In the long run, the high-earning and high-spending families fail to achieve financial independence, as they would not have the required quantum of appreciating assets which could give them the income they are used to. They will therefore have to keep on working, or suffer a fall in income after retiring.

Another interesting aspect explored in the book is the fate of the next generation which has grown up in affluence. Unless the parents (the self-made millionaires) have managed to instill the values of independence, self-reliance, and the discipline of frugality, living well within one’s means, the children of self-made millionaires are prone to be dependent on the wealth of their parents throughout their lives. The authors offer a lot of insights into how (some) affluent parents manage to achieve this with (some) of their offspring. There is also a lot about managing the estate, inheritance, distribution of the accumulated wealth, and so on that will be of interest.

Since their study is placed in America of the late 1990s, it may not be immediately applicable to Indian conditions. To facilitate translating their findings to the Indian scene. I find that multiplying American dollar amounts by 10 gives a broadly comparable Indian level. They define millionaires as those with a minimum of 1 million dollars in investments; an Indian family with net worth of 10 million rupees (what we call a crore) would be somewhat comparable in wealth and comfort levels. Some may like to have a higher ratio, but definitely we don’t have to multiply dollar figures by the full exchange rate (65 rupees or more to a dollar) to arrive at comparable levels!

Would the same principles of accumulating wealth hold in today’s world? Hearing many young persons speak, it may appear that the nature of the economic process has changed completely, that wealth is created in completely new ways, smart people can become millionaires over a weekend as something goes viral on the net, “winner takes all”, nobody has the time to plod along saving and building a miserable corpus. Well, I am not so convinced of this myself. The fact is that economies will be chugging along, and there will still be the usual avenues of investment: real estate, deposit certificates (fixed or term deposits as we call them in India), bonds and shares, and others I may not be familiar with. ¹ Flashy cars and swanky offices often only betray the fact that they are splurging on someone else’s money (equity contributors, shareholders, investors, lenders, banks), not that they are necessarily solid and prosperous. For individuals there is no doubt that the income stream has to be managed properly and apportioned sensibly between living expenses, liquid investments for intermediate expenses and emergencies, and investment assets including pension or provident funds, property, etc. I don’t think there is anything “around the corner” waiting for those who are thoughtlessly blowing away their current incomes in high consumption. At least, let them read this book and consider what it says … let them at least make informed choices!

¹Tax-free bonds are a preferred investment vehicle in America. I did a little internet inquiry into tax-free bonds here in India, and found that the government has cleverly limited their interest rate to 6% (tax-free) or 8% (taxed)!

Stanley, Thomas J. and William D.Denko. 1996. The Millionaire Next Door. The Surprising Secrets of America’s Wealthy. Published by Pocket Books, a division of Simon & Schuster Inc., New York, by arrangement with Longstreet Press, Inc., Marietta, GA, USA.

Classified at Dewey Decimal (DDC) 332.024 (Personal finance) in my personal library, in case you want to locate it in one!