In this second installment of the “In Defense of Frugal” series or the IDF series I will tackle what I said was the first measure of wealth. In the first post, “Are You A Millionaire?”, I tried to illustrate how frugality lent itself to wealth getting. In other words I tried to show success in building wealth is in large part due to how efficient one is at converting earned dollars into wealth dollars. Further, I said someone who earns a modest income may be much better at income-to-wealth conversion than someone who makes a handsome income. In fact, as I mentioned in the previous post, folks of moderate income tend to become wealthier than high income earners over the long haul. Of course it doesn’t have to be that way. High income earners have an advantage in that they have more funds available to invest. But that’s on a “gross” level. They “net” less of their funds because the majority instead spend those funds on items of little or no lasting value.
The concept that moderate income earners may be better at income-to-wealth converting than high-income earners is hard for most of us to wrap our minds around. Considering the high-income earners are driving luxury autos, live in large homes and spend lavishly on clothing, entertainment and travel. Most of us think, if these folks can buy all that stuff, how are they not rich? Well, they aren’t rich because they buy all that stuff. It is true, you cannot have your cake and eat it too. They’ve traded their potential wealth (and independence) for trinkets. Here are the facts as culled together by Dr. Thomas Stanley and American Express Publishing /Harrison Group:
- 87% of luxury motor vehicles are driven by non-millionaires. The most popular vehicles among high-income non-millionaires are Mercedes Benz and BMW. Most are leased. The most popular vehicle among millionaires is Toyota followed closely by Ford. Millionaires tend to purchase their cars.
- 73% of homes valued at over $1,000,000 are occupied by non-millionaires. They are purchased with jumbo mortgages with very little equity in place. In fact, many are under water right now. Millionaires on the other hand live in much more modest homes. 90% of millionaires live in homes valued at less than $1,000,000 and 28% live in homes valued at less than $300,000. Millionaires understand buying a more expensive home is likely to decrease the odds of becoming financially independent.
- Surveys conducted by Stanley and AmEx/Harrison showed similar results. Each survey focused on millionaires and high income earning non-millionaires on the subject of retailers frequented. Millionaires mentioned Target, Kohl’s, Costco and T.J. Maxx as most frequented. High income non-millionaires most cited stores were Banana Republic, Saks Fifth Ave, Neiman Marcus and Nordstrom.
I hear the boo birds chirping. Many of you reading this are probably saying, “What’s the point in having money if you can’t spend it on the finer things? Can’t I spend on the finer things and still get rich? After all, money is for spending, right?” I have to say I have a hard time arguing against this point. But over the years I’ve come to understand there is a time and a place for everything. Again, it is fine to spend. But not to the point that is sabotages your wealth building. This is where The Brick Wealth Ratio© comes in. It let’s us know if our current lifestyle will allow us to become financially independent.
Dr. Stanley first introduced his Wealth Equation© in his first book, Marketing to the Affluent. I first learned about it in his book, The Millionaire Next Door. Simply the equation says your net worth should be equal to 10% of your age times your annual realized household income:
Age / 10 x Income = Expected Net Worth (ENW)
Dr. Stanley states that if your net worth is double this figure, then he considers you wealthy given your age and income characteristics. However, although Stanley’s Wealth Equation is great it is flawed in that it does not give enough weight to age. Wealth grows exponentially over time, not linearly. It compounds on itself – interest earning interest. Stanley’s equation is linear. The equation is really only relevant for those who are in their 50’s and earn a pretty high income. For the equation to be useful, it must be relevant to most of us. Using Stanley’s equation as inspiration, I’ve developed an equation to estimate the median net worth of the person/household of median income in a particular age group. After some trial and error, the Brick Wealth Ratio© was born:
[(Age * Age) / (22 * (100 – Age))] * Income = Median Net Worth
According to the latest Survey of Consumer Finances (SCF, 2007) median income and net worth by age looks like the following:
If we plug the age and income figures above into The Brick Wealth Ratio© we come close to the figures in the SCF. An approximate gauge of median net worth is all we want.
The Brick Wealth Ratio© is the measure of how efficient one is at wealth creation. But there will be great disparity even among those who are pretty good at it. Stanley categorizes those whose net worth is double their Expected Net Worth as Balance Sheet Affluent or Prodigious Accumulators of Wealth (using his formula). The BAs/PAWs are those who rank in the top 25% in wealth in their age and income cohort. While those who are inefficient will only reach about half their Expected Net Worth. These are the Income Statement Affluent or Under Accumulators of Wealth. The IAs/UAWs rank in the bottom 25%.
It is instructive to do the same with the Brick Wealth Ratio©. Those in the top 25% are the truly wealthy. Their income, by the time they are 50 years of age or so, is about 8% or less of their net worth. But it is too simplistic to multiply the ratio by “2” and say these are the folks who belong in this group as Stanley does with his equation. The same problem remains as this would not account correctly for age and compounding. To solve this issue I use a multiplier that incorporates age:
Age / 15
Here’s the test. According to Stop Acting Rich, the typical millionaire in Stanley’s study is 57 years old and has a median income of $212,888 or about 4.3x the median income of the typical household. The median net worth of millionaire households, not including home equity, is $2.2 million. Once home equity is included in the figure rises to $2.7 million. If we plug the age and income of the typical millionaire into the Brick Wealth Ratio© we get pretty close to reality:
Try it for yourself:
So here’s the bottom line. The Brick Wealth Ratio© answers the question asked earlier, “Can’t I spend on the finer things and still get rich?” Yes you can. If you are a BA/PAW, then you are wealthy considering your age and income characteristics. As long as your spending doesn’t knock you out of the BA/PAW category, you are fine.
One note. Obviously this is a relative measure. You may belong to the BA/PAW group but not be truly financially independent. Especially if you are younger than 50 years of age. The Brick Wealth Ratio© is a gauge, a barometer of wealth. It tells you whether you are on track. I will tackle the measure of true financial independence in the next post.