Tuesday, June 17, 2014

Book Review #1: The Millionaire Next Door: Authors:Thomas J. Stanley & William D. Danko

Who do you think is richer? A neighbourhood garage owner who seem to be busy all the time, always in a Khaki pants and a Sweat shirt and drives a 4 year old Maruti Swift, or the neighbourhood doctor, who lives in a swanky apartment, has a six figure annual income, wears the latest Armani, sports the 50000 rupee mobile phone and drives around in an Audi...

Ok, I guess I gave away the surprise.

It is the doctor, right? 

Wrong. Chances are that your neighbourhood small business owner is richer than the doc who has substantially high income. 

That is the surprising conclusion that the book 'The millionaire next door' comes up with. As per the book, there are various reasons why a doctor is not as wealthy as he should be.

1. Doctors normally start earning late in their lives. The garage owner probably has a 10-12 year headstart over the doctor when comes to earning the income. This is applicable to many educated folks who spends a lot of time studying prior to entering the workforce.

2. Doctor has to live a 'high class' lifestyle. The profession of the doctor calls for a high class style of life. Since they are exposed to people all the time and are being judged regularly, the pressure to live up to your income is high in case of a doctor. They live in high end localities, wears expensive dresses, drives expensive cars all of which eats into their income leaving little as savings

3. Doctors have bad investment habits. They do not spend enough time on understanding wealth creation, do no learn about investing, are not consistent in investing and finally, tend to choose bad investment consultants and lawyers. 

The book is not about doctors, it is about millionaires. It is about how to become one. It is about the behavioural traits of wealthy people. The book is about what to do and what not to do to become wealthy. 

'Frugal' is a word that you see a lot in this book. The wealthy people are frugal. They live in inexpensive neighbourhood, stay in a 3 bedroom apartment for the last 20 years, most of them are self-employed (Two thirds of them), most have been married to and living with the same woman for over 20 years, they are very good at financial planning and their wives are better at financial management than they themselves are.

And they are frugal. They have conservative tastes, drives second hand cars and their spending on dress is only 33% of their more ostentatious neighbours.

The first question that the authors try to answer is 'What is Wealthy'? How do you define wealth?. The authors maintain that your wealth, which includes all your assets (House, Investments) less all your liabilities (Mortgage, Credit Card Debt) should be at least equal to your annual income multiplied by your age divided by 10. 

A person earning Rs.20 Lakhs per year and aged 40 years should have a wealth (also called 'Net Worth') of 20 Lakhs X 40 / 10 = 80 Lakhs. The authors call those who have wealth above this value as 'Prodigious Accumulators of Wealth (PAW) and those who have wealth below this as 'Under Accumulators of Wealth (UAW)'. What do you call those whose wealth is around this number? 

They are called 'Average Accumulators of Wealth (AAW)'

Authors argue that PAW share different behavioral traits from UAWs. We mentioned some of them above. In addition to the above, one fundamental difference between PAWs and UAWs lies in the nature of their income. Authors divide the income into two types. One is the unrealized income. These are incomes which keep accumulating but are not realized by the investor. These are in the nature of incomes which are due to appreciation in the value of their investments including investments in Stocks and Bonds. The characteristic of unrealized income is that since the income is not realized, you don't have to pay tax on the income. 

The other type of income is the realized income. This is the the income that you earn and which is credited in your bank account. Income from Salary is a good example. The moment the income is realized, it becomes eligible to be taxed at the personal income tax rate which in most countries is about 30%. 

Your total income is your realized income plus your unrealized income. 

Authors point out that PAWs usually pay between 2 to 3% of their wealth as income tax whereas a UAW will pay anywhere between 8-15% of their wealth as taxes in a year. That is because most of the income for a PAW is 'Unrealized' while that for a UAW is more 'Realized' in nature. 

Authors use an earthy Texan phrase for a person who looks and acts rich as 'All hat no cattle'. 

Other than being frugal, what else do PAWs do right? According to the authors these are the seven habits of wealthy individuals.

1. They live well below their means
2. They allocate their time, money and energy efficiently, in ways conducive to building wealth
3. They believe that financial independence is more important than displaying high social status
4. Their parents did not provide Economic Outpatient Care
5. Their adult children are economically self sufficient. 
6. They are proficient in targeting market opportunities
7. They choose the right occupation.

The wealthy people are very good at planning and budgeting. They have a clear idea of how much in a year they spent in Food, Clothing, entertainment etc. They also have clear financial goals and plans to meet those goals. 

In addition they spend a lot of time (Almost double that of the time spend by UAWs) in identifying the right professionals who can help them to generate unrealized income. They choose their lawyers and investment advisers very carefully. They own their investment decisions. They are consistent with their investments unlike the UAWs who are very inconsistent with their investment decisions. PAWs have investment plans and do not renege on their plans under any circumstance. UAWs invest in fits and starts. They are the targets of unscrupulous investment advisers. 

The average annual realized income of a wealthy person is about 6.7 percent of their wealth and they pay a tax of less than 2 percent of their wealth.

One interesting concept that the authors bring out is that of 'Economic Outpatient Care'. This is the phenomena where the adult children of UAWs are themselves UAWs and despite reaching their earning age, are still dependent on the support provided by their parents. Authors point out that since the behaviour of UAWs are responsible for their status as UAW, their children tend to inculcate their spending behaviour and themselves become UAWs.

Sometimes the opposite can happen. The book provides the example of a gentleman who grew up very poor. He was motivated to overcome his impoverished circumstances and studied very hard and reached a very successful position earning annual income in six figures. However, he was hellbent on trying to become 'Better Off' than when he was a child. He has a fleet of value depreciating assets. 

PAWs are also good at taking calculated risks. Where they see opportunities, they will invest in those opportunities. When it comes to UAWs they ignore opportunities. The authors discuss the case of multiple UAWs who despite working in blue chip companies like Microsoft or Walmart, do not own a single share of the company.

After reading this review you may wonder if you have it in you to become wealthy. The authors want you to answer the following four questions.

1. Does your household operate on an annual budget?
2. Do you know how much your family spends each year on food, clothing and shelter?
3. Do you have a clearly defined set of daily, weekly, monthly, yearly and long-term goals?
4. Do you spend a lot of time planning your financial future?

If your answer to the above questions is 'Yes' or 'Mostly Yes', then you are one of the lucky few to have what it takes to generate wealth.

Part of the book is tedious. For example, the authors spend considerable time on how much time UAWs spend on purchasing a car. Another complaint is that many of the points discussed in the book are not applicable to young people. Mind you, young people will benefit a lot by reading this book. The habits expostulated in this book are universal and are not age specific. But to expect a young person, barely into their working career to have a net worth calculated by the formula?

I mean, come on !

There is one area where I want to caution the readers. It is mentioned that wealthy takes calculated risks. This is an advice that I am very much worried about. The question is which came first, the wealth or the risk taking. One can say that wealthy can afford to take risks BECAUSE they are wealthy. In my opinion, by following a consistent savings and investment habit, one can build a very comfortable nest egg without taking too many risks. 

The authors have one advice for the youngsters who are at the beginning of their working life. "Start Investing Early". Perhaps, the same advice, removing the word 'Early' is applicable to all of us. 

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