Friday, September 8, 2006

Wealth According to The Millionaire Next Door

To answer the question of whether one is wealthy, I will take a quote from The Millionaire Next Door, by Thomas Stanley & William Danko, which I read a few years ago. I consider this book to be a classic. Here, the authors discuss what one's expected net worth should be at any given point in life.

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.

To give an example, suppose one is 35 years old and makes $100,000 per year. Then, by the above formula, one's expected net worth is $350,000. The authors then go on to describe the wealthy (prodigious accumulators of wealth, PAWs) as those who have at least double this expected net worth based on age and income. Conversely, one who has accumulated less than half of their expected net worth is known as an under accumulator of wealth, or UAW. (I have always found it peculiar that this acronym is the same as the one used by the United Auto Workers union, but that is another story.)

In any case, the suggestion by the two authors is a broad rule of thumb. I would caution one against putting too much weight into the usefulness of a rule of thumb. Nevertheless, armed with this knowledge, you can at least have a rough idea of where you stand with regard to what your savings should be at any point in time.

Update: See also As a Rule of Thumb...
and The Millionaire's Rule of Thumb.

pfstock

4 comments:

ny1er said...

I think that formula has some obvious deficiencies. It doesn't work for someone who has just started working, obviously. If you're 22 and make 100K a year, the formula says your net worth should be 220K.

Then at some point let's say your networth is exactly what the formula says it should be. Now there's another problem. The problem is basically saying that you should be saving 10% of your income a year. (Say you reach you achieve the net worth predicted by the formula at n. In year n+1, your incremental wealth should be at least (n+1) x income / 10 - n x income / 10 = income / 10.)

Saving 10% of income doesn't sound enough.

pfstock said...

I am aware of other deficiencies in the formula from The Millionaire Next Door. Consider the case where a person is in the PAW category, but gets pushed down because he got a big raise. On the other hand, if a UAW became unemployed, it is possible for that person to move from being a UAW to a PAW, based on his reduced income. Common sense alone tells me that there is something wrong with this logic.

mOOm said...

The formula also says you need to save a smaller and smaller fraction of income as you get older which doesn't make a lot of sense. It is saying that you need to save a lot less than 10% of labor income assuming that your assets are earning a real return and growing. Say at age 40 I earn $50k and have $200k in assets. At a 5% real return they would grow by $10,000 a year all by themselves. Yet if my income doesn't rise I only need to add $5000 a year to get to $300k by 60. So I can actually dissave according to the model. OK - so let's assume that the investment income is counted in income. I think it is pretty easy to see that this doesn't change things a lot...

pfstock said...

I understand your point. But actually, the authors described this calculation as yielding one's "expected net worth". This is the point at which one becomes an average accumulator of wealth. To be "rich", you need to have double this amount. This is a point that many readers of The Millionaire Next Door miss.

So using your example, one would need to have $400k in assets to be a PAW. Clearly, the key is that getting into the PAW club to start with requires extra effort. Also realistically, one's real wage can be expected to rise over time.