Jun

3

Book Review: The Millionaire Next Door

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When I first read The Millionaire Next Door: The Surprising Secrets of America’s Wealth by Thomas Stanley and William Danko many years ago, it forever changed my beliefs about what it takes to be wealthy. I used to think that I was going to have to work my butt off by either starting my own company or by working my way up the corporate ladder of someone else’s company. The Millionaire Next Door taught me that this might give us a high income, but it won’t necessarily make us wealthy. Too often people equate having a high income with being wealthy, and I think that I was unconsciously making this same connection. It finally began to dawn on me that it isn’t how much you make, but rather how much you keep. In retrospect, this seems like a flash of the blindingly obvious. I think that it took me a while to really understand this point because society has a tendency to program us with the flawed “high income equals wealth” paradigm, and I bought into it without really thinking about it. As Stanley and Danko explained:

“Most people have it all wrong about wealth in America. Wealth is not the same as income. If you make a good income each year and spend it all, you are not getting wealthier. You are just living high. Wealth is what you accumulate, not what you spend.”

Who is the millionaire next door?

Stanley and Danko began to study how people become wealthy, and they made an unusual discovery. Many people that appear to be wealthy are not wealthy at all, and many people who don’t appear to be wealthy are in fact very wealthy. People with big houses, nice cars, and tons of possessions often have little net worth, or worse, they have a negative net worth (to learn more about net worth, read my post Keep Score by Tracking Your Net Worth). If their incomes were interrupted for whatever reason, they wouldn’t be able to survive very long on what they had saved. On the other hand, people with modest houses, cars, and possessions often have a high net worth. They could survive without an income quite comfortably for years. These are the “millionaires next door.” Your neighbor with the average size house and a Toyota Camry in his driveway could very well be a millionaire, and you wouldn’t know it. They made one other discovery that really piqued my interest:

“Eighty percent of America’s millionaires are first-generation rich.”

This tells me that the old expression that “it takes money to make money” is just plain wrong. America is truly the land of opportunity if you are willing to do what it takes to become wealthy. Unfortunately, most people either don’t believe this is true or they are just unwilling to do what it takes.

The Seven Factors of Wealth

Stanley and Danko identified seven common denominators among those who successfully build wealth. They are:

1) They live well below their means.

2) They allocate their time, energy, and money 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 chose the right occupation.

The book goes into detail on these 7 factors, so I won’t do it here.

How Wealthy Should You Be?

Your level of wealth is obviously going to depend on several factors such as your age and your income. Other things equal, you would generally expect a 50-year old person to be wealthier than a 25-year old, and you would expect a 50-year old earning $100,000 to be wealthier than a 50-year old making $25,000 per year. Stanley and Danko try to answer the question: “Whatever your age, whatever your income, how much should you be worth right now?” I don’t like this question, because it assumes that there is one right answer to how much wealth we each should have. I think the amount of wealth that we have should be dependent on our values, and these are going to vary widely from person to person.

In any case, Stanley and Danko came up with a formula to compute a person’s expected net worth:

“Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.”

I think this is an incredibly stupid formula, and it has been widely criticized by readers of the book. As an example of the formula’s shortcomings, let’s say you are 25 years old and are fortunate enough to earn $100,000 per year. Your expected net worth according to the formula would be $250,000 (25 X $100,000 / 10). Assuming you graduated when you were 21 and assuming that you didn’t start out making $100,000 per year, you would probably need to save more than 75% of your pre-tax income when you were 22, 23, and 24 to be worth $250,000 by the time you are 25. This would be pretty challenging considering that you would pretty much have to live on nothing after you paid your taxes.

The Difference between PAW’s and UAW’s

You can forget about the formula, but it is worthwhile to pay attention to the distinctions that they make between the prodigious accumulator of wealth (PAW) and the under accumulator of wealth (UAW). PAW’s build significantly more wealth relative to others in their income/age category. Stanley and Danko do an excellent job of describing the characteristics that distinguish PAW’s from UAW’s. The most critical point is that PAW’s live significantly below their means. UAW’s don’t accumulate much wealth because they overspend. This is the dominant theme throughout the book, and rightly so. Living below your means is simply much more important in accumulating wealth than having a high income.

Conclusion

For me, The Millionaire Next Door was one of the most important books on becoming wealthy that I have ever read. It doesn’t provide specific approaches on how to invest or build a business or any number of things that you will find in other books about getting rich, but it provides an essential philosophy to work from. It had a significant impact on me in terms of convincing me of the relative importance of “playing good defense” (i.e. keeping my spending low) versus the importance of “playing good offense” (having a good income). While good offense will obviously help you win the game, always make sure that a strong defense remains a priority. As Stanley and Danko wrote:

“Millionaires play both quality offense and quality defense. And quite often their great defense helps them outscore/outaccumulate those who outearn/have superior offenses. The foundation stone of wealth accumulation is defense, and this defense should be anchored by budgeting and planning.”

I found parts of the book somewhat dull, especially in the second half of the book, but I highly recommend reading this book to anyone who is serious about becoming wealthy.

Other Reviews of The Millionaire Next Door

The Profit Advisors review - “I have read every page of this book. I found The Millionaire Next Door
to be fascinating, educational reading and recommend it enthusiastically. Give it or loan it to family members. Be sure to put it on your summer reading list. Then take action on what you learn, and I’ll have a lot of wealthy clients!”

The It’s Your Money review - “The Millionaire Next Door
is an exceptional book, and I must recommend it highly. It could be particularly useful if one were just beginning a financial-improvement regimen and needs a dose of the “big picture” outlook which only large-scale surveys can provide. Overall, TMND is full of lightbulb moments and, for those of us who cannot help but shake our heads at the High-Consumption Crowd, a great many self-gratifying conclusions.”

John T. Reed’s review - “One of the best books ever on millionaires is currently at the top of a business book best seller list: The Millionaire Next Door by Ph.D.s Thomas Stanley and William Danko.”

The Simple Dollar review – “I give the book a “buy” recommendation if you are over the age of forty, if you have substantially greater assets than many people in your age group, or you are interested in long-term financial planning. The book does a great job of outlining what people should be doing in middle age if they want to build substantial wealth (and enable their families to carry on this tradition) for their later years.

On the other hand, I give the book a “not buy” recommendation if you are young and without appreciable assets. At this point in your life, the focus should be on building a solid foundation for your financial life and this book does little to address that topic. Your time and attention is almost assuredly better spent somewhere else.”

May

27

Book Review: Rich Dad, Poor Dad

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Before I read Rich Dad, Poor Dad: What the Rich Teach Their Kids About Money – That the Poor and Middle Class Do Not! by Robert Kiyosaki, I was pretty skeptical. I had seen Kiyosaki briefly on TV, and I was somewhat turned off. However, Rich Dad, Poor Dad was such a high-selling book for so long that I finally decided to check it out of the library and see what all the hubbub was about. Although the book has several flaws, I actually liked the book more than I thought I would, and I think it was worth reading.

Rich Dad, Poor Dad sparks wildly different opinions among readers. I wasn’t the only person who had very mixed opinions of the book, which can be seen from the other reviews at the end of this post. One thing that jumped out at me was how poorly edited it was. I read extensively, and poor editing tends to irritate me. I read very quickly, and poor editing slows me down. I also didn’t like Kiyosaki’s views of taxation. He suggests setting up a corporation. It’s bizarre that he associates setting up a corporation with building wealth. The double-taxation associated with corporations makes them tax inefficient. Most companies these days are set up as LLC’s in order to provide limited liability and avoid double taxation. The other problem is that he seemingly encourages the use of a business to deduct what otherwise would be personal expenses. I believe in using tax strategies to reduce your taxes within the bounds of the law, but I think he is being very sleazy in trying to get away with deducting things that aren’t really deductible.

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

- Judge Learned Hand -

The Rich Are Different

Despite the negatives, there are several things that I agreed with. The dominant theme of the book is that rich people think differently from poor people. Throughout the book, Kiyosaki talks about his “poor dad,” who was his real father, and his “rich dad,” who was actually his friend’s father that became a financial mentor to him. He does a respectable job of describing the differences in the way the rich people and poor people think. I think that this point is extremely important. Our thinking is what causes the biggest differences in our lives, because the way we think determines the actions that we take and therefore the results that we get.

The most important concept in the book is the idea that the rich buy assets and avoid liabilities. As Kiyosaki says:

“Rule One. You must know the difference between an asset and a liability, and buy assets. If you want to be rich, this is all you need to know. It is Rule No. 1. It is the only rule. This may sound absurdly simple, but most people have no idea how profound this rule is. Most people struggle financially because they do not know the difference between an asset and a liability.

Rich people acquire assets. The poor and middle class acquire liabilities, but they think they are assets.”

He goes on to give definitions of assets and liabilities that he admits are different from the accounting definitions, but I think they are very useful definitions when it comes to building wealth:

“An asset is something that puts money in my pocket. A liability is something that takes money out of my pocket.

This is really all you need to know. If you want to be rich, simply spend your life buying assets. If you want to be poor or middle class, spend your life buying liabilities.”

One example that he talks about is a car. Most people consider a car to be an asset, but he considers it to be a liability because it costs us money. In a sense, I agree with him. Your car won’t build your wealth, so it makes sense not to think of it as an asset. Kiyosaki also makes the controversial claim that your house is not an asset because it doesn’t put money in your pocket. I have mixed feelings about this view. Although a house doesn’t put money in your pocket, you are investing in something with increasing value, so my opinion of owning a house isn’t nearly as negative as Kiyosaki’s. However, I do think that most people overstate a house’s value as an investment. Without rental income, the rate of return on real estate is much lower. According to the OFHEO house price index, houses appreciated at about 4.6% annually from January 1991 through March 2008. According to the Case-Schiller Index from January 1987 through February 2008, houses appreciated about 5.4% per year. Obviously you are giving up some return compared to investing in the stock market as a tradeoff to be able to live in the house. This isn’t necessarily a bad tradeoff, but you should take it into account when making the decision to buy a house.

In any case, Kiyosaki emphasizes buying assets to increase your cash flow, which allows you to buy more assets and increase your cash flow further, creating a virtuous cycle. I agree with this view 100%. Most people are not rich because they simply don’t use their cash flow to buy income-producing assets. They spend virtually all their money on things that don’t leave us any better off financially. It’s no wonder so many people make little or no financial progress from year to year.

Money Won’t Solve Your Problems

Kiyosaki said something else that resonated with me because it agrees with what I believed already:

“More money will often not solve the problem; in fact, it may actually accelerate the problem. Money often makes obvious our tragic human flaws. Money often puts a spotlight on what we do not know. That is why, all too often, a person who comes into a sudden windfall of cash – let’s say an inheritance, a pay raise or lottery winnings – soon returns to the same financial mess, if not worse than the mess they were in before they received the money. Money only accentuates the cash-flow pattern running in your head. If your pattern is to spend everything you get, most likely an increase in cash will just result in an increase in spending.”

We see this happen all the time. The stories of lottery winners, athletes, and celebrities coming into huge sums of money and then declaring bankruptcy only a few years later are all too common. This is why I keep emphasizing the importance of the way you think in building wealth. If you consistently run mental patterns for wealth in your mind, then you will very likely be wealthy. If you don’t seem to be making any progress towards wealth, then you are almost certainly not running mental patterns that lead to wealth.

Conclusion

In my personal opinion, Rich Dad, Poor Dad is worth reading. There are some important wealth concepts in the book, and it is an easy read. As with any book, I recommend reading it critically, thinking about the ideas very carefully, and taking from it whatever ideas make sense to you. You can discard the ideas you disagree with. So go to your local library and pick up a copy. I’ll leave you with one final quote from the book:

“As a teacher, I recognized that it was excessive fear and self-doubt that were the greatest detractors of personal genius.”

So true.

Other Reviews of Rich Dad, Poor Dad

The Simple Dollar review - “The only reason to buy this book is if you really, really need inspiration and didn’t already find it in Your Money or Your Life. If that’s not true for you, don’t buy this book and don’t waste your time on it.”

The bainvestor.com review - “With three books on the bestseller lists, I thought we should give one of Robert T. Kiyosaki’s books a read. Rich Dad, Poor Dad was a very irritating book. On the one hand, there was some great information given. On the other hand, there also was some seriously flawed advice given, which could lead to becoming “broke” as Kiyosaki prefers to call it.”

I Will Teach You to Be Rich review - “This book is like the kid you hated in high school, but he let you cheat off his test a couple of times so you kind of like him. I have grudging respect for this book, but every time someone raves about it, I usually just want to punch them in the face.

Rich Dad, Poor Dad is an absolute juggernaut of a book–it’s been on the bestseller lists for as long as I remember. I re-read this book yesterday. Man, there are some really great points, like how rich people make money work for them and how everyone else works for money. The first chapter is pure magic – read it.”

May

21

Book Review: Buffett: The Making of an American Capitalist

Filed Under Book Reviews, Investing, Warren Buffett | 1 Comment


It’s no secret to those who know me well that I’m a huge fan of Warren Buffett. I probably talk about him too often and with too much excitement, but they understand that he is someone that I admire. As long as I can remember, I’ve always had the idea that the most effective way to get better at something is to find out what the people at the top of their fields do and learn what makes them the best. When I started playing soccer at the age of 8, I went to the library and checked out books about Pele, possibly the greatest soccer player ever. Even if you can’t duplicate what the masters do, learning what makes them successful will give you insights that you can apply to improve your results.

The World’s Greatest Investor?

For those of you who don’t know who Warren Buffett is, he is currently the world’s richest man according to the latest Forbes list of richest people in the world. He is unusual in that he is one of the only people on the list that made his money through investing. Buffett is arguably the greatest investor of all time. When he ran an investment partnership from 1957-1969, he racked up a compounded annual return of 29.5% a year, beating the Dow Jones Industrial Averages by an astonishing 22.1% per year over a 13-year period. What’s even more remarkable is that he didn’t lose money in a single year over those 13 years! Achieving returns like that over an extended period of time without losing money is almost unheard of.

He followed up that masterful performance by taking over a company called Berkshire Hathaway on May 10, 1965 and used his investment acumen to increase the stock price from $18 a share to its current price of about $123,000 a share. That’s not a typo. Berkshire Hathaway hasn’t split its stock since Buffett took over, so the stock price has continued to grow, much to the chagrin of the typographers of financial publications. The stock price of Berkshire Hathaway has compounded at about 22.8% a year since he took over in 1965. If you study Buffett’s investment decisions, you learn that he makes these huge investment gains while rarely taking a loss. It was this unique ability that intrigued me to learn more about how this was possible.

Buffett: The Making of an American Capitalist

During my initial search for Buffett’s secrets of investing success back in the mid- to late-1990s, I ran across Roger Lowenstein’s biography called Buffett: The Making of an American Capitalist. Although I may be biased because of my admiration for Buffett, Buffett is the best biography I have ever read. The book is extremely well researched and is very detailed, as can be seen from the beginning of Chapter 1:

“Almost from the day that Dr. Pollard awakened him to the world, six pounds strong and five weeks early, Warren Buffett had a thirst for numbers.”

Lowenstein continues this level of detail throughout the 423 pages of the book, but for the most part it feels natural rather than tedious. The details about some of the deals that Buffett has done might be a little excessive for some people, but with my love of investing, I personally thought that they were interesting. Lowenstein is a talented writer who wrote for the Wall Street Journal for more than a decade and is very knowledgeable about investing and finance. I have read numerous excellent articles by Lowenstein over the years.

Buffett’s Destiny as a Great Investor

If you are curious about how Buffett achieved such amazing investment results, let me warn you that the amount that you will learn from Buffett: The Making of an American Capitalist about his investment philosophy is somewhat limited. This is a biography rather than a book about investing. That being said, Lowenstein’s book does a great job of describing the formative influences that made Buffett the man he is today. It almost seems that Buffett was destined to be a great investor. He was born with a great mind for numbers and an amazing memory, and he seemed to be born with a burning desire to become wealthy. At the age of five, Buffett would buy six-packs of Coca Cola for 25 cents and sell the bottles for 5 cents a piece, earning a nickel profit. He made money in all sorts of business ventures while he was growing up, and then he would carefully count his growing capital.

The events in his life also seemed to be very serendipitous in leading him to his future as a great investor. About the same time that Buffett was disappointed by a rejection from Harvard, he happened to read a book that had been recently published called The Intelligent Investor by Benjamin Graham. Buffett was so impressed by the investment philosophy in Graham’s book that he decided to study under Graham at Columbia University’s graduate school. He later was given the opportunity to work under his mentor when he got a job working for Graham’s investment partnership. Graham’s teachings quickly formed the core of Buffett’s philosophy. Another serendipitous event occurred when Buffett met the brilliant Charlie Munger, who continues to be Buffett’s friend, business partner, and sounding board to this day. Munger was an important contributor to the evolution of Buffett’s investment philosophy. Buffett would have been a great investor even if he had never met Munger (who is an interesting character in his own right), but Munger’s influence helped take Buffett to a whole new level.

Conclusion

Buffett is a great book, one that I enjoyed so much that I have read it several times over the years. I have read many books about Buffett, but this one stands above the rest. I highly recommend it to anyone who is curious about what makes Warren Buffett tick, and if you are interested in studying Buffett more thoroughly, I can’t think of a better place to start than Buffett: The Making of an American Capitalist.

Other Reviews for Buffett: The Making of an American Capitalist

The Simple Dollar review - “Buffett: The Making of an American Capitalist is a very good biography. Buffett is a highly compelling subject, and with Lowenstein’s skill, it’s easily the best biography I’ve read of a modern investor, and it’s one of the rare books that I will keep and read again. If you have any interest in who Warren Buffett is as a person, pick this up and read it - it’s well worth the time.”

The New York Times review - “Aside from this odd and unconvincing bit of speculation, everything else rings true, and Mr. Lowenstein has done a masterly job over all. Once again, Mr. Buffett was right not to meddle in the business at hand, and in spite of his not saying anything directly to the author, Mr. Lowenstein has picked up numerous examples of his wit. Here’s an exchange from the annual meeting of Berkshire Hathaway, when a questioner in the crowd expressed fear of Mr. Buffett’s death:

‘I’m thinking of making a purchase of Berkshire,’ the person said, ‘but I’m concerned about something happening to you, Mr. Buffett. I cannot afford an event risk.’

Came the reply: ‘Neither can I.’

The bainvestor.com review - “Buffett: The Making of an American Capitalist is an excellent and thorough biography of Warren Buffett, one of the world’s greatest investors. For serious investors that might be a bit of history worth reading.”

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