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Saturday, February 1, 2014

It's Not What You Earn, It's What You Save (Millionaire Next Door Book Review)

  This entry discusses the importance of the savings rates in personal finance. Rather than cover this ground myself, I will instead refer to a classic of personal finance, The Millionaire Next Door (affiliate link) by Thomas J. Stanley and William D. Danko. I will end off with some comments on the macro significance of their work - the inherent tendency for capitalist systems to generate wealth inequality.

If you have tried running simulations of retirement planning, a key variable is how much you can save. The impact of changing the saving rate parameter will probably swamp the settings of other variables (other than assuming an extremely high rate of return on assets). The reason is two-fold:

  1. If you save more, you end up with more assets at the end of each year.
  2. If you save more, you are by definition spending less. You need less retirement income to support the standard of living you have become habituated to

Barring outside resources (like an inheritance or winning a lottery), if you are spending 99% of your peak income, you are going to end up in trouble. This is even true if you have a very high income, and that 1% savings generates an optically large amount of money. Sports and pop stars who have gone from extremely high incomes to bankruptcy are depressingly common.

I am not a financial planner, but my impression that the basic problem many people face is that they are unaware that the amount you save (and spend) can actually vary. However, if you have achieved "middle class" status, you can spend wildly different amounts to achieve what is essentially the same outcome. (Within Canada and the United States, "middle class" is a wide range of lifestyles and incomes; I believe that this is also true for most of the developed economies.) For example, you can at least double your spending on autos just by increasing the number you own and/or replacing them more frequently, and you do not even need to step up to buy premium models. However, if you do not question your spending, all spending ends up being "necessary", and thus saving appears impossible.

The book "The Millionaire Next Door" looks at this issue in detail. The authors based the book on their analysis of the characteristics of marketing to the affluent. What they found is that the rich (millionaires) did not match popular stereotypes. What surprised them at first was that the rich generally did not buy luxury goods; they were mainly purchased by high income earners who wanted to "look rich" but actually had very little assets.

I believe the book is effective as it just does not dump statistics and equations on the reader (like the author of this blog would probably do...), rather it illustrates the data with interesting case studies. To take one example, the authors look at two highly successful physicians with annual incomes of $700,000, "Dr. North" and "Dr. South". Despite having the same income, Dr. North had assets of $7,500,000 (over 10 years of pre-tax income) versus $400,000 for Dr. South (about 7 months of pre-tax income). They explain why with juicy details - for example, Dr. South's family spent $30,000 on clothes in the past year.

One of the points they hammer home is that the high status occupations - big city lawyers and doctors in particular - do not do particularly well in generating savings, despite high incomes. They tend to live in expensive neighbourhoods, and keeping up appearances is costly (country clubs, private schools). For this reason, millionaires are more likely to be found in a middle class neighbourhood, and they managed to avoid expensive status symbols. (Hence, they are the millionaire next door of the title.) Successful small business owners generate a significant proportion of millionaires; they often do not want to look too rich so as to avoid aggravating relations with their employees.

The book is somewhat dated now (it was published in 1996), but there have been other updates. I have also read a more recent book by Thomas J. Stanley (only) - Stop Acting Rich: ...And Start Living Like A Real Millionaire (affiliate link). This book covers a lot of the same ground, but it is more tightly focussed on the marketing aspects. It has also some comments with respect to housing wealth, in light of the U.S. housing market crash. (The similarity to the original book means that one could probably read one or the other.)

The second book's focus on marketing  also provides entertaining anecdotes. My personal favourite was his discussion of premium vodka. Marketers have somehow managed to convince people that their brand of vodka is premium and worth paying a lot for. However, this is the face of the U.S. Federal Government's definition of vodka (quoted in the book):

Vodka ... without distinctive character, aroma, taste, or color.
I never really paid attention to the premium vodka fad (is it still going on?); as a third generation Ukrainian-Canadian, I was socialised to think that vodka was what poor people in the Old Country drank. But the fact that people pay top dollar for what is essentially straight alcohol tells us how much flexibility there is in consumer budgets in the developed economies.

In summary, I think the book will be effective for at least some people (this will depend on personal taste). By covering the topic from a wide number of angles and with case studies that can be related to, the message should be memorable. Additionally, these are not just anecdotes; the stories are based on data. It probably makes sense to follow the strategies followed by a large number of people who became wealthy, rather than follow some rules of thumb written down by someone who may have just become wealthy as the result of good luck.

Postscript: The Millionaire Next Door And Inequality

There have been a lot of recent discussions on the internet about inequality. This is a politically-charged issue. However, these discussions often mix the distinction between the distribution of wealth, and the distribution of income. The data behind the Millionaire Next Door underlines that you cannot confuse the two concepts.

Much of the furore over inequality revolves around the hyper-rich; the various billionaires that populate the media circus. This wholesale level of inequality is not really what I am talking about here; I am looking at "retail inequality" - where incomes are around $200,000 or less (which was most of the cases in the book, and certainly the bulk of the population).

If we look at the example of Dr. South and Dr. North above, we see that for the same income, the ratio of assets between the two was a factor of 18.75. So even if we manage to flatten the income distribution, we still can have a huge disparity of wealth. This is not too surprising, given that the rate of saving for financial assets is negligible for a wide section of the population. (Savings has often been in the form of paying for housing, which is not the same thing as saving for financial assets, as I argued here.)

If you modelled this behaviour, even if salary incomes are the same, assets will be increasingly concentrated amongst households with high savings rates. And this will be augmented if there is a tendency for frugal parents to have frugal children - the wealth will be increasingly concentrated in these families over time.

Therefore, it is no accident that the distribution of wealth is becoming more unequal over time. And since this is an innate tendency for a mixed economy, I do not see any easy way of stopping this trend, even if the political will existed to do so.

(c) Brian Romanchuk 2014


  1. Great review, Brian.
    Its scary when you read about stats that Canadians are barely saving and contributing to their retirement funds these days. Sadly, Canadians consider their over-inflated house prices a retirement plan.

    1. Thanks. I read the "financial makeover" stories in the Globe and Mail (I think; they are reprinted in the Montreal Gazette), and the number of people who have massive real estate holdings (house, cottage, rental unit) and no financial assets is scary. I assume that the people who are profiled are not representative (they want "interesting stories" for the newspaper), but it is mind-boggling looking at these people finances. If they all have to sell at the same time - ouch.

  2. Some interesting stuff, there.

    It's good to see you stress the distinction between income and wealth inequality. Most work tends to focus on income inequality, partly I suspect because the impact of wealth inequality is harder to analyse, but I think the dynamics of wealth have very important implications for spending patterns. I could do with thinking about it more.


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