The Millionaire Next Door describes the financial habits of thousands of millionaires surveyed across the U.S. The findings of the book were mind blowing, as they showed a trend of everyday people becoming millionaires through rudimentary ways. For instance, many of them were very frugal, living in middle class residential neighborhoods even though they could afford to live in more posh surroundings.
The results of this book may have disappointed some. Isn’t the way to wealth a riddle wrapped in a mystery inside an enigma? Isn’t it only achievable by an elite group of individuals and privileged families?
The answer is a resounding “NO,” but don’t be fooled into thinking such results are easy to come by either. Indeed, becoming wealthy may be simple, but we would see far more wealthy families if it was easy.
How Becoming Wealthy Is Simple
The way to wealth is quite straightforward. I could quote academic research here or relate specific experiences of families who have successfully become wealthy the simple way, but I’ll instead highlight some points of what I believe it takes to get there.
(Editor’s note: While I believe there are many ways to build wealth, I believe the simplest way for most families is to utilize tax-advantaged investment accounts and company-sponsored saving plans. My remarks below follow this line of thinking.)
Start growing wealth early for greater compounding growth
Time is an essential key to successfully growing wealth. The doubling penny example illustrates why. If you could have $1 million now or a penny that doubles everyday for 30 days (Day 1 = 1 penny, Day 2 = 2 pennies, Day 3 = 4 pennies…) which would you take?
I hope you chose right. While daily (not to mention monthly or even yearly) returns of 100% are impossible, the example illustrates the importance of time and compounding growth. By day 30 the compounding penny results in around $5.5 million! The key is starting early and being willing to make it through days 1-20 without giving up. The real “compounding magic” happens in days 25 to 30. Similarly, diligent saving takes decades of persistence--when it doesn't look like your 401(k) is growing much--and patience through the ups and downs before bearing fruit.
Consistently Invest 10-15% of Your Salary in tax-advantaged accounts
401(k)s, Roth and Traditional IRAs all carry tax-advantages by either allowing pre-tax contributions and paying taxes later (hopefully at lower income tax levels), or after-tax contributions, where taxes are already paid so your future withdrawals are tax-free.
This is crucial to understand. Being able to pay taxes later means the money is used for growth instead. Pair this with a consistently high savings rate of 10-15% (including a company 401(k) match, if available) and you have a great formula for wealth growth.
Choose a Wide Variety of Investments
Spreading your money across a wide variety of investments (diversification) means that suffering a loss of any one investment will not ruin you financially.
To further illustrate, you could take your entire savings and invest it into the stock of one or two companies. But what if one of those companies went bankrupt? You would lose a significant portion of your investment. Diversification demands that your money is spread across many, many different types of investments. For instance, your 401(k) likely contains a variety of mutual funds which invest in hundreds or even thousands of different companies. The impact of one company going under in a mutual fund is far less severe than if you had half your money in one failing company’s stock.
Keep Your Investment Costs Low
Fees are the silent killer of many wealth building strategies. In the investing world, these equate to transaction costs for buying and selling investments, a fee you may be paying a financial advisor, and annual expense ratios for, say, a mutual fund in your 401(k). What makes these fees so dangerous is their amounts feel relatively tiny, however, these small amounts can have an impact of hundreds of thousands or even millions of dollars over the years, as illustrated below*. For instance, note the difference between an investor's portfolio value below after 40 years of a 1.00% fee versus a 2.50% fee.
Table illustrates portfolio value after fees. See disclaimer at end of article for details.
If this is difficult to picture, think of it this way. Why do homeowners go through the process of refinancing a mortgage, even if their rate will only be a half percent lower? They do this because they know that over the course of 30 years this lower rate will result in a bundle of saved money. The same rule applies to lower investing fees.
To be clear, I don't think there's anything wrong with paying reasonable fees for a financial advisor or owning a mutual fund. But you should know how it will impact you financially.
To better understand the impact of investment fees, take a look at this excellent article from NerdWallet on the topic.
Why Becoming Wealthy Isn’t Easy
The 2008 market crash happened in the middle of my first year as an MBA student. It was sheer pandemonium. Professors were running up and down the hall shouting about how the market had dipped another 5, 10, or 15%--sometimes in a single day. I’ll never forget a classmate saying, “I can’t take this. I’ve sold everything in my 401(k) and will get back into the market when things look better.”
The psychological impact of market drops like in 2008 are what make building wealth NOT easy. Success requires being consistently invested, not sitting on the sidelines, despite the ups and downs. I hope my friend was able to get back into the market as it reached its bottom, but history shows that investors are bad market timers. Chances are he reinvested late, missing the full 8-year upturn, or he still hasn’t reinvested to this day.
This is just one example of what gets in the way of growing wealth. There are so many other factors to wrestle with and they’re almost all emotional: excess spending on “good-feeling” non-essentials, high interest borrowing on credit cards, and buying the home in the posh neighborhood, despite what most “millionaires next door” are doing.
Slow and Steady Progress towards wealth
Kellie and I sat down the other day to see how we’re progressing toward our retirement goal. We calculated (based on certain assumptions) that if we don’t contribute another dime to our investment accounts, we’ll have about $1.2 million when we retire. That’s less than our goal, but it feels incredible to see our progress.
We’re normal people. We put our pants on one leg at a time. We did benefit from a few years of having a dual income, but neither of us have ever had six figure salaries. We’ve simply been early, steady, diversified, and fee-conscious investors. We’ve tried not to freak out when the market dips and have kept a long-term view of growing wealth. We’ve kept our living expenses reasonable enough to keep our retirement contributions around 10-15%.
I hope this article brings a little clarity on how to approach growing your wealth and the psychological pressures that can get in the way.
*Impact of fee assumptions:
$10,000 tax deferred annual investment, in monthly increments
8% nominal returns while working
Fees could be as low as 0.1% and as high as 3%
Investing starts at age 22 and retirement at age 62
Source: http://www.physicianonfire.com/investment-fees-will-cost-millions/