Personal Finance Musing 14: The Road to Riches
PERSONAL FINANCE MUSING 14
THE ROAD TO RICHES: QUANTIFYING STEPS TO WEALTH
We pick up the threads from where we left last week i.e. to define in concrete terms a yardstick of wealth that one can follow depending on one’s life stage and age. But before that, my impassioned plea - please keep sharing these posts with your near and dear ones especially young adults, for these are a run up to my book, “Musings of a (financially) illiterate father”, likely to be in your hands next month. The book has been specially written to teach the alchemy of wealth creation and retention to our children. They deserve to learn it.
We are continuing our journey through the brilliant book, ”The Millionaire Next Door” written by Thomas J. Stanley and William D. Danko, in 1996. The authors wrote this book after their extensive research on American millionaires spanning many years. The research brought out many surprising conclusions which we, as common middle-class persons, would do well to emulate, if we too wish to become a millionaire in one generation.
1. The Road to Riches: How Wealthy Should You Be?
“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.”
Let’s demystify this yardstick with an example. Suppose you are 40 years old with an annual gross salary of Rs 12 lac. Your net worth should then be Rs 48 lac (40 *Rs 12 lac/10). Of course, this is the “ideal net worth” one should have but life is never utopian and in actual one’s net worth will be more (less likely) or less (more likely) than this ideal figure. The net worth is incidentally a total of all your assets less liabilities. If you are still unclear about what is an asset and liability, please go through my post on this topic. The link is given below.
The authors have further given a few practical yardsticks to slot oneself appropriately on the “wealth scale”. They have also introduced few important terms.
Prodigious Accumulator of Wealth (PAW): If your net worth is twice or more than the level expected as per above equation.
Under Accumulator of Wealth (UAW): If your net worth is half or less than the level expected as per above equation.
Average Accumulator of Wealth (AAW): Anyone in between UAW and PAW.
Getting back to our ongoing example, if one's net worth is Rs 96 lac or more, he is a PAW. If it is Rs 24 lac or less, one is a UAW. Anyone in between these two figures will be an AAW- of course, the one closer to Rs 96 lac will be a happy AAW while the one closer to Rs 24 lac-well you decide for yourself.
I will urge you to calculate your net worth on an excel sheet and then keep a track of it every quarter. It should keep increasing. If it is not so, please take steps that I have been enumerating in my musings to nudge it in the positive direction. This one step alone will instill fiscal discipline in your life leading to abundance.
2. Big Hat and No Cattle. A big problem with (Upper) Middle-Class people is their need and aspiration to maintain a lifestyle which clearly their income can't sustain. They need to wear certain kind of clothes, live in a certain kind of neighborhood (where people much better off than they live), dine in certain kind of restaurants, drive certain kind of cars and go to certain (or costlier) holiday destinations. The list is endless. I'll recommend you to watch the delightful movie, "Hindi Medium" starring Irrfan Khan, to experience this point in action.
When we compare a lower-middle-class person's lifestyle to the one described above, we find that they don't have pressure to "show off" and hence are content with a lifestyle which generally is bereft of the "rich trappings". So they can still use a two-wheeler, go for vacations to “Nainital” and buy vegetables from the local "Sabzi Mandi". In the bargain, they are able to actually save/invest much more than their "Upper Middle Class" counterparts. Over time, the magic of compounding (for lower-middle-class persons) and tyranny of compounding (for Upper middle-class persons ) works, as it should, and we find the financial fortunes of their next generations change for the better/worse.
“It is unfortunate that some people judge others by their choice in foods, beverages, suits, watches, motor vehicles, and such. To them, superior people have excellent tastes in consumer goods. But it is easier to purchase products that denote superiority than to be actually superior in economic achievement.”
Of course, what I am postulating is not the universal truth and there are fiscally prudent upper middle-class persons and extravagant lower middle-class persons. But overall, the need/desire of resources to maintain a “rich” lifestyle is bound to be more with an upper-middle-class person.
“Perhaps you aren’t as wealthy as you should be because you traded much of your current and future income just for the privilege of living in a home in a high-status neighborhood.”
If we combine this point with the previous one (net worth), we come to the obvious conclusion- that one’s wealth doesn’t directly depend on one’s income. So, a lower-middle-class frugal person may be an AAW while an upper-middle-class ostentatious person may be a UAW. Frugality in life remains the key to long-term wealth accumulation, and being frugal is not being miserly. The dictionary meaning of frugal is, "behavior characterized by or reflecting economy in the use of resources" meaning that the person is not wasteful, ostentatious and a spendthrift.
This simple truth often eludes many of us. All we need to do is to ensure that we are strictly living within our means and not on credit where we spend tomorrow’s income today (credit cards are an apt example). I will exhort you to read my post on spending- investing (SI) balance where this issue has been deliberated upon in detail. The link is provided below.
“Do not spend tomorrow’s income today. This will keep you off the earn- and- consume treadmill”.
3. Habit is the Key.
“Sow a thought, and you reap an act;
Sow an act, and you reap a habit;
Sow a habit, and you reap a character;
Sow a character, and you reap a destiny.”
Sow an act, and you reap a habit;
Sow a habit, and you reap a character;
Sow a character, and you reap a destiny.”
I am very fond of my morning jogs/walks which are almost religious to me, the most cathartic activity in the day that I undertake. As I see the people who are on the road/gym every day I can't help but think- they look fit, why do they need to run/walk. Of course, the answer is pretty obvious; they are fit because they are in a habit of morning runs. The same is true with wealthy people- when one sees their frugality; one knows the foundation of that wealth.
The SI Balance will give you the discipline in life to get your financial priorities right. Do follow it scrupulously for long-term "financial habit forming”. When you get a pay raise, a bonus, an unexpected windfall- you know what to do with it? Invest it, at least 50% of it.
4. Build Financial Muscle.
"On average, millionaires spend significantly more hours per month studying and planning their future investment decisions, as well as managing their current investments, than high-income non-millionaires."
This point was also highlighted in the book, “The Richest Man in Babylon”, which I reviewed on 29 Apr and 06 May. The links are provided below. The ironical truth is that an AAW person, who can afford to take a financial hit, is always very careful about his investment decisions. A UAW on the other hand, despite having little financial capital, will be more careless or reckless with his financial decisions.
The difference between the two is due to their financial education levels. An AAW person keeps acquiring and updating his knowledge while a UAW finds more important topics to invest time in. So, Trump-Putin tiff, NBA matches, Stand-Up comedies, the latest fiction and so on, will keep a UAW busy. Gaining financial knowledge will be the last of his/her priority. Don't get me wrong- it is not my pitch that all the topics I have mentioned above are not worthy of spending time upon. All I am saying is that keep a few minutes dedicated to gaining financial knowledge as well.
I sign off here for today. We will wrap up this set of musings next week, on 17 Jun, with the balance of the "wisdom nuggets" from this wonderful book. For now, enjoy your Sunday- you have earned it.
A 'reality check exercise' which nudges us to act . Simile of financial prudence with physical fitness is very apt. Following your blog will certainly make us a wise person financially sir. Thanks a lot for enlightening us sir.
ReplyDeleteThanks for following my blog.
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