One of the most influential books I read, while on my journey to financial independence and becoming a millionaire was, The Millionaire Next Door by Dr. Thomas Stanley. This book was particularly enjoyable for me, as an aspiring wealth builder, because it refutes a commonly held perception of what millionaires look like. There are two competing views of millionaires, and we’re going to break them down.
The media shows millionaires lounging poolside after arriving at their private tropical island in their personal helicopter. But this is not the whole picture.
While there are mega-millionaires that enjoy that type of lavish lifestyle, most millionaires enjoy a simpler way of life. They might even live next door to you!
There’s more than one way to make a million dollars, such as starting your own business or buying multiples rental properties. Investing in the stock market is another great path to millionaire status.
So, how do millionaires save and invest? Here are some of the most common steps they take.
1. Minimize Taxes
Millionaires strive to keep taxable income low by using tax deferred savings options like 401k’s and IRA’s. Avoiding a huge tax bill means extra money to fund additional investments. After initially contributing to a 401k or IRA, the tax savings continue year after year, as dividends and capital gains are sheltered from taxation in these accounts.
Investing in a taxable account can also be tax efficient. By keeping trading activity to a minimum, and therefore not incurring large capital gains, most stock portfolios won’t generate a lot of taxable income other than dividends. Most dividend income is subject to low income tax rates (or zero income tax rates for those in the lowest tax brackets!).
2. Keep Investment Costs Low
With a seven figure portfolio, the unwary millionaire can be eaten alive by investment fees. The difference between paying 0.1% per year in expenses on the lowest cost mutual funds and ETF’s, versus 1% for a standard actively managed mutual fund is only 0.90%. That’s a fraction of a percent and doesn’t seem huge. But consider 0.90% of $1,000,000 and we are talking about $9,000 in extra fees — per year.
For investors that pay a percentage of their assets for advice from their financial advisor (often on top of 1% fees on mutual funds!), there can be another percent or two siphoned off their portfolio each year. That’s $10,000 or $20,000 on a million dollar portfolio. So a big part of managing their investments is keeping their costs and fees to a minimum.
3. Pay Close Attention to all Ventures
Dr. Stanley illustrates the point well in The Millionaire Next Door. Millionaires spend an average of five or six hours per week on financial planning (including managing investments) whereas those with a lower net worth tend to spend an hour per week.
Focusing on finances and investments literally pays off. By paying attention to what you’re spending, what you are making, and where you keep your financial assets, you can make more optimal decisions and place investments in higher performing asset classes and higher yielding fixed income investments.
4. Take Calculated Risks
Millionaires take risks when the odds are in their favor. A large part of being able to take risks is having the wealth available to put at risk. To a millionaire, a $20,000 or $30,000 loss on an investment gone bad won’t send them to the poor house. Consider what those losses would do to a household living paycheck-to-paycheck and you can easily see why millionaires can afford to take such calculated risks.
Millionaires don’t limit their investments to only stocks and bonds. Many use capital to start a business or invest in private equity deals that require high initial investments.
5. Buy Appreciating Assets
Most millionaire finances and investments are actually pretty boring, and look nothing like the stereotypical millionaires shown in glossy travel magazine advertisements. They own relatively simple cars (sedans and pick up trucks, often domestic makes) and live in moderately priced houses.
In addition to saving a significant portion of their income in tax deferred savings vehicles like 401k’s and IRA’s, they also save 20% or more of their income in investment accounts. Millionaires know that cars tend to lose about 10% of their value per year, whereas stocks tend to gain about 10% per year.
Even though houses are often depicted as appreciating assets, they don’t appreciate all that much. The Nobel Prize winning economist Robert Schiller has studied housing price data from the last century, and figured out that real estate has increased in value at an average of one percent above inflation per year.
Add in all the expenses for insurance, taxes, and maintenance, and buying a big house to live in turns out to be a pretty poor investment. That doesn’t mean real estate is always a bad investment. Many millionaires were minted by buying real estate and renting it out to produce income.
Top Investing Traits of Millionaires
Pardon the chest-thumping for a minute, but as a self-made millionaire, I’ll admit to sharing all five of these traits. In my investment portfolio, you’ll see a lot of tax efficient low cost mutual funds.
I don’t know if I spend six hours per week managing my finances, but I certainly spend an hour or two to check on my asset allocation and redeploy idle cash. I actually just spent a few hours figuring out my tax liability for 2014, and am taking a few steps to save a few thousand dollars in taxes.
I’ve always welcomed reasonable risks in my investment portfolio since I know that these risks tend to pay well in the form of long-term gains (in spite of occasional short term losses). And I’ve never been a big fan of acquiring a lot of depreciating assets (just take a look at my very average house and fourteen year-old cars!).
Readers: are you a self-made millionaire? Or do you know one? What are a few investing traits you’ve noticed?