RPF0451-The_Millionaire_Next_Door_Wealth_Index
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00:00:14.320 | - Welcome to Radical Personal Finance,
00:00:17.280 | the show dedicated to providing you with the knowledge,
00:00:19.080 | skills, insight, and consistent daily encouragement
00:00:22.240 | you need to live a rich and meaningful life now
00:00:25.200 | while building and working on your plan
00:00:27.400 | for financial freedom in 10 years or less,
00:00:29.560 | fighting the sniffles today.
00:00:31.360 | So today's show is going to be extremely short
00:00:34.520 | and to the point, but I wanna talk with you
00:00:37.160 | about the Millionaire Wealth Index.
00:00:42.160 | I'm drawing this from the well-known book,
00:00:44.800 | "The Millionaire Next Door" by Tom Stanley
00:00:47.680 | and William Danko.
00:00:49.280 | This seminal work was published about 20 years ago.
00:00:51.960 | In fact, I just realized that they published
00:00:53.920 | a 20th anniversary edition, which I have not yet gotten,
00:00:57.120 | which I need to look up and get a copy
00:00:58.640 | of the 20th anniversary edition
00:01:00.760 | to see how they've updated that since the passing
00:01:03.240 | of Dr. Tom Stanley back in 2015.
00:01:06.520 | Interested to see how they've updated the research,
00:01:08.880 | interested to see if there have been any changes
00:01:11.200 | that have occurred since then.
00:01:13.320 | In the beginning of "The Millionaire Next Door,"
00:01:15.200 | the authors talk about how to define the wealthy.
00:01:18.180 | After all, they're writing a book about the wealthy.
00:01:20.320 | The subtitle of the book is called
00:01:21.600 | "The Surprising Secrets of America's Wealthy,"
00:01:24.280 | and they talk about some different ways
00:01:26.080 | to discuss and to categorize wealth.
00:01:28.920 | This is not actually an easy question to answer.
00:01:32.740 | Words have meanings depending on where we are.
00:01:37.360 | We ascribe the meaning to a word
00:01:39.840 | based upon our own personal experience,
00:01:41.940 | our own personal knowledge,
00:01:42.920 | and our own personal use of the word.
00:01:44.440 | I do this every day.
00:01:45.600 | In my little intro there that you just heard
00:01:47.440 | where I said, "Show dedicated to helping you
00:01:50.160 | "to live a rich life now
00:01:53.040 | "while building a plan for financial freedom
00:01:55.820 | "in 10 years or less,"
00:01:57.320 | depending on how you're stumbling into that slogan,
00:01:59.680 | you'll interpret that differently.
00:02:01.560 | For example, I personally live a very rich life now,
00:02:06.040 | and I want you to live a rich life now.
00:02:09.820 | But some people define that term rich
00:02:11.880 | in the context of driving a luxury automobile.
00:02:14.560 | I place a lot more emphasis
00:02:17.520 | on having an intellectually rich life
00:02:21.520 | than I do on driving a luxury automobile.
00:02:24.520 | I place a lot more emphasis
00:02:25.960 | on having freedom and control over my time
00:02:29.360 | than I do on having a luxury timepiece on my wrist.
00:02:32.900 | Of course, your mileage may vary,
00:02:35.640 | but that's the definition that I've chosen
00:02:37.740 | for living a rich life now.
00:02:41.620 | Similar things with financial freedom.
00:02:42.940 | When I talk about financial freedom,
00:02:44.360 | as I've made clear in previous shows,
00:02:47.120 | that word can be applied in various ways.
00:02:49.640 | I consider somebody who is not overwhelmed with debt,
00:02:52.440 | who has more income than they do expenses
00:02:54.440 | to be financially free.
00:02:56.440 | I also consider somebody who's financially independent,
00:02:59.400 | meaning able to live on the income
00:03:01.320 | from their investment portfolio, to be financially free.
00:03:05.440 | Some people can be financially free on $20,000 a year,
00:03:08.680 | and some people cannot be financially free on $200,000 a year.
00:03:13.560 | And so we face the same problem with the word wealth.
00:03:16.280 | Different people define wealth,
00:03:18.320 | or the state of being wealthy, differently.
00:03:22.560 | Some people think about having a lot of stuff,
00:03:25.020 | a lot of material possessions,
00:03:26.720 | and having a lot of luxury items.
00:03:29.800 | However, that definition can be misleading.
00:03:33.700 | And in the book "The Millionaire Next Door,"
00:03:35.040 | the authors don't talk about wealth or affluence
00:03:38.840 | in terms of material possessions.
00:03:42.360 | One major reason for this is sometimes
00:03:44.520 | there can be a positive relationship
00:03:46.280 | between wealth and material possessions.
00:03:48.680 | Somebody who has a lot of material possessions,
00:03:50.960 | especially even including luxury material possessions,
00:03:54.040 | might indeed be extremely wealthy.
00:03:56.560 | But sometimes there can also be an inverse,
00:03:58.600 | negative relationship between wealth
00:04:00.760 | and material possessions.
00:04:02.040 | After all, it's possible that somebody
00:04:04.120 | has spent all their money buying material possessions,
00:04:07.520 | and thus they don't have any other forms
00:04:10.240 | or sources of wealth.
00:04:11.620 | So how do you get a little closer?
00:04:14.680 | Net worth should certainly be a factor.
00:04:17.080 | Net worth, meaning the value of somebody's assets,
00:04:20.480 | minus their liabilities,
00:04:23.120 | that number could be high or could be low.
00:04:26.200 | And you could have a high net worth
00:04:28.200 | and a lot of material possessions,
00:04:30.280 | or you could have a high net worth
00:04:31.760 | without a lot of material possessions.
00:04:33.480 | So net worth is useful.
00:04:35.440 | And generally, in Tom Stanley's research
00:04:38.480 | in "The Millionaire Next Door,"
00:04:40.760 | they discussed net worth in the context of
00:04:43.920 | usually most of their profiles and research respondents
00:04:47.080 | had a net worth an average of between one and $10 million.
00:04:50.480 | Of course, these numbers were published in 1998.
00:04:54.280 | And in 1998, if you had a net worth of a million dollars,
00:04:58.680 | although it wasn't worth as much as it was in 1978,
00:05:02.800 | in today's dollars, in 2017, as I record this,
00:05:06.040 | you would have to accumulate $1,496,788.
00:05:09.040 | So let's just call that $1.5 million among friends
00:05:16.800 | to have the same amount of buying power as you had in 1998.
00:05:21.800 | So here we are coming up on the 20th anniversary
00:05:25.000 | of this book, and we would need to adjust this.
00:05:27.280 | The respondent who was worth a million dollars
00:05:29.720 | would need to be worth now in today's dollars, $1.5 million.
00:05:33.600 | That is a useful consideration.
00:05:37.400 | The actual nominal or stated dollar value is valuable
00:05:42.400 | and is worth considering.
00:05:44.660 | But that doesn't take into account
00:05:46.280 | two important characteristics
00:05:48.400 | or two important pieces of data,
00:05:50.560 | namely, how long have you had to build wealth?
00:05:55.560 | We would define that in age or possibly number of years
00:06:00.120 | working and accumulating money.
00:06:02.280 | And how much income have you had to work with?
00:06:06.400 | Somebody who has turned a $50,000 annual income
00:06:10.100 | into a $1 million net worth
00:06:12.680 | has been a much better saver, investor,
00:06:16.020 | and manager of wealth
00:06:17.940 | than somebody who has turned a $500,000 income
00:06:22.620 | into a $1 million net worth, given similar amounts of time.
00:06:27.460 | In order to factor all these things together,
00:06:30.720 | the authors came up with a simple formula
00:06:33.780 | to calculate how much wealth they said you should have.
00:06:38.700 | And I think this is a very valuable formula.
00:06:42.380 | I don't know whether it's particularly valuable
00:06:45.700 | still in the context of calculating
00:06:49.180 | anything across populations.
00:06:52.020 | I don't know the usefulness of this.
00:06:53.900 | But I do think it's a useful consideration
00:06:56.460 | for us to know for ourselves.
00:06:58.000 | And I also think it's valuable to look at the factors
00:07:00.620 | that are involved in this wealth index.
00:07:03.680 | Here's the formula.
00:07:06.100 | The authors say that the formula is to multiply your age
00:07:10.380 | times your realized pre-tax annual household income
00:07:15.380 | from all sources except inheritances and divide by 10.
00:07:20.840 | This, less any inherited wealth,
00:07:23.760 | is what your net worth should be.
00:07:25.620 | Now, let me simplify that to make it a little bit
00:07:27.500 | more easily grasped in an audio format.
00:07:31.980 | Take your age, multiply it by your income, divide by 10,
00:07:34.780 | and that's what your net worth should be.
00:07:36.380 | So if you are 40 years old
00:07:38.060 | and you have an annual income of $50,000 per year,
00:07:41.940 | multiply those together and you come up
00:07:43.500 | with a number of $2 million.
00:07:44.820 | Divide that number by 10
00:07:47.500 | and you wind up with a number of $200,000.
00:07:51.420 | And your net worth should be about $200,000
00:07:56.060 | if you're about normal or average.
00:07:58.540 | And by that I mean normal or average as a wealth builder.
00:08:00.840 | I don't know, again, any comparison here
00:08:03.500 | to the average population.
00:08:05.260 | But you're listening to Radical Personal Finance,
00:08:07.380 | you're not the average population,
00:08:08.980 | and averages don't particularly matter.
00:08:11.860 | They might be useful for sociologists to study
00:08:14.100 | or economists to study,
00:08:15.340 | but they don't make much of a difference
00:08:17.180 | in your life or in my life.
00:08:18.940 | It's a funny anecdote,
00:08:21.380 | but I always think of this when I think of averages.
00:08:23.620 | Somebody made the quip somewhere that
00:08:26.420 | if you take one bucket of water
00:08:28.140 | and you fill it up with boiling water,
00:08:29.780 | and you take another bucket of water
00:08:31.560 | and you fill it up with ice water,
00:08:33.700 | on the whole, on the average, you'll be pretty miserable.
00:08:36.940 | And the point was, yes, if you put the hot water
00:08:39.220 | and the cold water together, on average,
00:08:41.220 | the temperature should be comfortable,
00:08:42.820 | but in your case, you're miserable,
00:08:44.420 | depending on where you are
00:08:45.820 | and which foot you happen to have in which bucket.
00:08:48.460 | So I don't know what that means.
00:08:50.540 | I just think it's always funny
00:08:51.660 | that averages are useful to be aware of,
00:08:54.300 | but they're not useful for running your life.
00:08:57.740 | In order to think about the next category,
00:09:00.980 | which the authors, and before I go on,
00:09:03.760 | I encourage you, take a moment,
00:09:05.180 | and you can do this in your own mind.
00:09:07.780 | Take your current age, measured in years,
00:09:10.800 | multiply it by your current income.
00:09:14.300 | Just round it off.
00:09:18.100 | So age times income, and think what that number is.
00:09:22.340 | And then divide by 10, and the simplest way to do that
00:09:24.580 | is just move your decimal point one place to the left.
00:09:27.700 | So again, 40 years old, $100,000 of income.
00:09:31.880 | In that situation, you would have,
00:09:34.140 | the number would be $4 million.
00:09:35.980 | Move the decimal point one place to the left,
00:09:39.580 | and you would now have an expected net worth of $400,000.
00:09:43.860 | Now, from here, though,
00:09:45.580 | we should add a little bit of texture.
00:09:48.440 | The authors use two categories in "The Millionaire Next Door."
00:09:51.580 | One is a PAW,
00:09:53.820 | which is an acronym for prodigious accumulator of wealth.
00:09:58.320 | A PAW is a prodigious accumulator of wealth.
00:10:01.620 | Also, a UAW, or an under accumulator of wealth.
00:10:06.620 | And of course, if you desire to be profiled
00:10:10.780 | as being wealthy, then you would want to be in the PAW,
00:10:15.780 | the prodigious accumulator of wealth category.
00:10:19.340 | In order to be well-positioned as,
00:10:22.980 | and characterized as a PAW,
00:10:26.180 | the authors state that you should be worth twice
00:10:28.220 | the level of wealth expected.
00:10:30.540 | If you are 40 years old, earning $100,000 per year,
00:10:35.100 | and you want to know, am I doing really well?
00:10:37.980 | Am I in the top quartile?
00:10:39.180 | Am I a prodigious accumulator of wealth?
00:10:41.620 | Well, in that case, your expected net worth of $400,000,
00:10:45.220 | you would like to be able to see that about double, $800,000.
00:10:49.000 | So these numbers might be able to give you a sense
00:10:52.560 | of how you're doing.
00:10:53.860 | If you're younger, for example, if you're 30 years old,
00:10:57.220 | and you have an annual income of $50,000,
00:11:00.980 | and you apply this formula,
00:11:02.860 | well, your expected level of wealth is $150,000.
00:11:06.300 | If you've accumulated half a million dollars in savings,
00:11:10.260 | or $300,000, and 150 in your 401k,
00:11:13.820 | and $100,000 of equity in your house,
00:11:16.140 | and $50,000 of savings, you're doing really, really well.
00:11:19.740 | You're on track.
00:11:21.700 | And so there are a few reasons I want to profile
00:11:23.620 | this formula for you.
00:11:25.320 | Number one, I want to encourage you
00:11:26.860 | that either you're on track,
00:11:28.820 | or you might want to adjust things a little bit.
00:11:31.760 | The reason it's important to recognize you're on track
00:11:34.780 | is you have to go with,
00:11:38.340 | you have to look and compare yourself
00:11:40.420 | to people who are in a similar situation as you.
00:11:44.980 | And this is why I want to break this down.
00:11:46.620 | The two big factors are your age and your income.
00:11:51.680 | Don't, if you're 30 years old,
00:11:53.800 | don't compare yourself and your level of wealth
00:11:57.500 | to somebody who is 50 years old.
00:12:00.100 | Compare yourself to other 30 year olds,
00:12:04.500 | because in general, you're going to have started working
00:12:06.480 | at a different time than they did,
00:12:08.240 | and you've got to compare yourself to a similar category.
00:12:12.080 | Likewise, if you're earning a very high income,
00:12:15.480 | don't compare yourself to people
00:12:17.040 | who are earning a low income and think,
00:12:18.680 | oh, look, I'm doing great.
00:12:20.120 | Compare yourself to people who are also earning
00:12:21.980 | a high income, who are good producers of income.
00:12:24.840 | Compare yourself to these peers.
00:12:28.760 | In order to do that,
00:12:29.880 | you're going to have to find some kind of formula,
00:12:31.600 | because it's going to be hard for you to find similar peers
00:12:34.200 | who are at similar amounts of age and similar income.
00:12:36.840 | I think the use of something like a wealth index
00:12:40.400 | is a valuable and useful way for you
00:12:42.360 | to get a sense of how you're doing.
00:12:44.280 | Couple of caveats.
00:12:45.800 | If you are very young, don't look to this
00:12:49.560 | as a source of authority.
00:12:51.960 | Whether you're very young because you are very young
00:12:55.080 | in terms of your actual age,
00:12:57.440 | if you're 20 years old or 25 years old or 30 years old,
00:13:01.160 | or if you're very young in terms of the amount
00:13:04.080 | of the number of years that you have been working,
00:13:07.160 | you cannot look to a formula like this.
00:13:10.440 | The most extreme example would be somebody
00:13:13.480 | like a recent doctor, a recent graduate from medical school,
00:13:18.760 | or some highly trained, highly specialized occupation.
00:13:22.440 | A recent graduate from a medical school
00:13:24.920 | may be half a million dollars in the hole.
00:13:27.280 | Their net worth may be minus $500,000,
00:13:29.760 | and they have gotten out of school in their early
00:13:33.520 | or going on mid 30s, and they have no wealth accumulated yet.
00:13:37.600 | That doesn't mean that you are,
00:13:39.920 | that doesn't mean that you're necessarily inefficient.
00:13:42.440 | Stanley, in one of his blog posts on this topic,
00:13:45.020 | later wrote and recommended to his readers
00:13:48.360 | that they adjust their age and pull out all the years
00:13:50.960 | that they've been in school
00:13:52.040 | as a way of adjusting the formula.
00:13:54.440 | You will be extremely wealthy,
00:13:57.600 | and this formula will be very helpful for you
00:14:01.120 | when you reach about, say, 45 or 50 years old.
00:14:04.080 | But when you're just getting out of school,
00:14:05.520 | or if you're very young, these results,
00:14:07.580 | the results of this wealth index
00:14:08.920 | are not particularly useful to you.
00:14:11.240 | One other point on this topic that I want to emphasize
00:14:14.280 | of how you can game the formula.
00:14:17.100 | It's always good to look at something and see,
00:14:19.140 | how could I manipulate this if I were going to manipulate it?
00:14:23.080 | And I want to point out the huge possible point
00:14:27.400 | of manipulation in this formula,
00:14:29.880 | which is something that you should manipulate
00:14:32.240 | because, as is written later in the book,
00:14:34.880 | this is what the wealthy manipulate.
00:14:37.660 | I read verbatim.
00:14:39.940 | Multiply your age times your realized pre-tax annual
00:14:45.160 | household income from all sources except inheritances.
00:14:50.160 | Divide by 10.
00:14:52.520 | This less any inherited wealth
00:14:54.480 | is what your net worth should be.
00:14:56.120 | Do you catch one of the biggest factors
00:15:00.460 | that you can manipulate?
00:15:01.420 | You can't manipulate your age.
00:15:03.720 | But what can you manipulate?
00:15:05.940 | I read again with emphasis.
00:15:08.520 | Multiply your age times your realized pre-tax annual
00:15:14.080 | household income from all sources except inheritances.
00:15:19.080 | The key way to game a formula like this,
00:15:29.900 | and in this context, gaming is a good thing
00:15:32.940 | because it means you're going to be
00:15:35.080 | a much more efficient accumulator of wealth,
00:15:37.660 | is to play with that word realized.
00:15:43.600 | Now, in tax lingo, what realized means
00:15:47.200 | is money that you've actually received.
00:15:50.520 | You would talk about this in the context of real income.
00:15:54.600 | Real income is money that you've actually received
00:15:58.220 | as compared to phantom income,
00:15:59.800 | which is income that you pay tax on,
00:16:01.800 | but you don't actually receive.
00:16:04.560 | Examples of phantom income would be things
00:16:06.440 | like zero coupon bonds, where you are accruing interest,
00:16:11.960 | but you're not, which you're paying tax on the interest,
00:16:15.800 | but you're not actually receiving any money
00:16:18.440 | because you'll receive the interest
00:16:21.480 | that's being assigned to you
00:16:23.800 | when you actually sell the bond.
00:16:25.120 | Or another example of phantom income would be
00:16:27.120 | when you have a debt that is forgiven by a creditor.
00:16:31.240 | If you have a creditor that forgives you a $10,000 loan,
00:16:34.520 | you are going to incur $10,000 of income,
00:16:38.680 | and you're gonna owe the tax on it
00:16:40.400 | so you could save your effective tax rate, or 20%.
00:16:43.680 | You would owe $2,000 of taxes on that money,
00:16:47.320 | which the IRS will collect on,
00:16:49.320 | but you never actually realized any income.
00:16:51.560 | That's called phantom income.
00:16:53.000 | So that's what realized and unrealized income is.
00:16:57.000 | The other word that is important is recognized income,
00:17:01.600 | meaning when do you actually recognize a gain or a loss?
00:17:05.880 | Sometimes with certain types of income
00:17:07.720 | or certain types of losses,
00:17:09.160 | you can choose to recognize them at different times.
00:17:12.060 | The point is the lower your realized income,
00:17:16.960 | the lower your expected net worth.
00:17:22.240 | And so what the wealthy people generally will want to do
00:17:27.920 | is to lower their realized income
00:17:31.360 | and to keep the money efficiently invested.
00:17:38.520 | Because if you can lower your realized income,
00:17:41.120 | you have the opportunity to keep it invested
00:17:46.280 | if you control the source of that income.
00:17:49.440 | If you're just simply offered two job options,
00:17:51.320 | job A pays you 50 grand a year,
00:17:52.960 | and job B pays you 100 grand a year,
00:17:54.960 | and you have no equity stake whatsoever,
00:17:57.640 | then in that circumstance,
00:17:59.520 | you better take the $100,000 a year.
00:18:02.240 | But if you own the company
00:18:03.680 | and you have the choice to either
00:18:05.360 | take a job paying $50,000 a year
00:18:07.600 | or to take a job paying $100,000 a year,
00:18:09.920 | and you're 100% shareholder of the company,
00:18:14.360 | it's in your best interest, probably,
00:18:17.040 | as long as the company is doing well,
00:18:18.880 | to keep that realized income number as low as possible.
00:18:23.600 | Yes, that games the formula,
00:18:26.280 | but as you read later in the book,
00:18:28.240 | it's one of the best ways to game the formula
00:18:30.720 | because it allows you to keep the money
00:18:33.760 | because it allows you to continue investing the money
00:18:38.760 | without it getting out into the wild
00:18:41.960 | and wooly world of taxed dollars.
00:18:45.640 | Calculate that formula for yourself.
00:18:49.120 | Use it as a useful rule of thumb.
00:18:53.760 | Don't put too much stock in it, but don't ignore it.
00:18:57.040 | Think about what you learn from it.
00:18:58.720 | Multiply your age times your realized
00:19:00.720 | pre-tax annual household income
00:19:02.640 | and all sources except inheritances,
00:19:04.280 | divide by 10.
00:19:05.960 | That, less any inherited wealth,
00:19:09.840 | is what your net worth should be.
00:19:12.320 | This show is part of the Radical Life Media Network
00:19:17.160 | of podcasts and resources.
00:19:19.400 | Find out more at radicallifemedia.com.
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