Wednesday, January 3, 2007

The Millionaire's Rule of Thumb

In the landmark book, The Millionaire Next Door by Thomas J. Stanley and William D. Danko, the authors present a now well-known formula for one's expected net worth. Unfortunately, it seems that the result of the formula has been repeatedly misinterpreted as a hard limit, where if you are below this number, you are considered "poor", and if you are above it, you're "rich". But, there is not a single break point that divides Prodigious Accumulators of Wealth (PAWs, the "rich") and Under Accumulators of Wealth (UAWs, the "poor"). Instead there is a broad middle range that the authors call Average Accumulators of Wealth (AAW).

Admittedly, the way in which Stanley and Danko presented the formula for expected net worth in their book is perhaps the source of much of this confusion. (See Wealth According to The Millionaire Next Door.) To be a PAW one needs to have at least twice their expected net worth. Instead of repeating the often misinterpreted formula here, I will present a simplified version of what the authors tried to convey in their book.

Take your age, and divide by 5. Multiply the result by your annual income. If your net worth is at least that amount, then you are a PAW (i.e. wealthy).

Suppose that one is 40 years old and has an annual income of $75,000. In this case, 40/5=8. So, to be "rich" at 40, one needs to have 8X their annual income or $600,000 in this example.

But, you are not necessarily a UAW if you have less than $600,000. The converse formula is:

Take your age, and divide by 20. Multiply the result by your annual income. If your net worth is less than that amount, then you are a UAW (i.e. "poor").

Using the same example, 40/20 = 2. So, one is poor at age 40, if their net worth is less than 2X their annual income, or $150,000 in this case.

I think that blog posts that discuss The Millionaire Next Door often illicit responses like: "The formula is flawed," or "This is nonsense." Indeed, broad rules of thumb like this one can have their limitations. I think that the authors only intended this formula to be a rough measure of one's wealth. On the other hand, if you find yourself making excuses as to why you can't achieve at least the lower limit of AAW status, then you are exactly what the authors have profiled as a UAW. My definition of a UAW is one that fits the formula and has a dozen "reasons" why he or she is stuck there.

Another typical reaction to the Millionaire's formula is people who say the formula is nonsensical, and that they will then develop a new and improved formula. Presumably, this new formula will show that they aren't doing so badly after all. In any case, I won't hold my breath for a new and improved breakthrough formula to come out.

Regardless of whether or not you agree with the Millionaire's Rule of Thumb, I think that everyone can strive to do better. Let me offer these words of encouragement: If you are a UAW, you can strive to become an AAW; if you are an AAW, you can strive to become a PAW. I wish you good luck in this endeavor.

Further Reading:
Wealth According to The Millionaire Next Door.
As a Rule of Thumb.

PF Stock


fin_indie said...

Great post. I've always wondered about that formula. Meaning, why do they use "current income", which presumably has risen year over year for some time -- it's the largest income most people have on record. I haven't done any comparative calcs, but it seems like using a median income value might yield a more reasonable result for most people.

dunkelblau said...

Sorry, this metric doesn't make sense to me. Are they saying that if my boss comes in and doubles
my salary that I suddenly become poorer?

I agree that wealth should be measured in units of time rather than dollars, but the correct denominator is annual expenses, not annual income. You're ready to retire when your networth divided by your annual expenses reaches 100 minus your age in years.

That's the real number.

pfstock said...

dunkelblau: I have written a new post in response to your comments and "new" wealth formula. Please see Do You Need 60X Annual Expenses to Retire Early?"

Thanks for your comments!