Want to Be a Millionaire?

by Motley Fool Staff

t's tough to make money with investments. As Fool contributor Selena Maranjian pointed out in an article last month, you have to consider inflation, taxes, and investment costs, all of which drag down your returns.

For instance, say you expect stocks to earn 10% per year. Once you subtract 3% for inflation, 2% for investment costs, and another 2% for taxes, all you've got left is 3% per year.

And numbers are even worse for bonds or money market funds.

Perhaps these assumptions are a tad pessimistic, but the general point remains valid: You can't count on 20% returns year in and year out, as investors got used to during the 1990s. As such, it's critical to have a backup plan for achieving your financial goals. For guidance on what such a plan might look like, let's see what we can learn from people who have already achieved a substantial degree of wealth: millionaires.

Characteristics of millionaires
According to a fascinating book I highly recommend, The Millionaire Next Door (published in 1996, so the statistics are dated, but the conclusions are not), here are some characteristics of millionaires that might surprise you:

  • "More than 80% are ordinary people who have accumulated their wealth in one generation. They did it slowly, steadily, without signing a multimillion-dollar contract with the Yankees ..."
  • Fewer than 20% inherited more than 10% of their wealth, and more than half never received a penny of inheritance.
  • They "wear inexpensive suits and drive American-made cars. Only a minority ... drive the current-model-year automobile."
  • About half have lived in their current home for 20 years or more.
  • 80% are college grads, and 38% have advanced degrees (which reminds me of the bumper sticker: "If you think education is expensive, try ignorance").
  • 20% are retired. Of those still working, about two-thirds are self-employed -- mostly entrepreneurs, but also self-employed professionals, such as doctors and accountants.
  • On average, they invest nearly 20% of their household realized income each year.

OK, so most millionaires aren't rock stars or scions of wealthy families, but surely they have high incomes, right? Think again. Their median annual income was a mere $131,000. So how did they become millionaires? The answer is so simple it sounds trite: "They live well below their means."

In short, the book explains most millionaires are "FRUGAL, FRUGAL, FRUGAL ... Being frugal is the cornerstone of wealth-building ... The affluent tend to answer "yes" to three questions: 1) Were your parents very frugal? 2) Are you frugal? 3) Is your spouse more frugal than you are?"

Yet we've become more a nation of consumption than of frugality. Freely available credit has made it easy for Americans to take on debt to live above their means. Consider:

  • Consumer credit -- which includes most types of debt other than mortgage loans -- stands at nearly $2.5 trillion, versus $800 billion in the early 1990s and just $350 billion in the early 1980s.
  • Debt service as a percentage of disposable income was around 11% in the mid-1990s, but has now risen to more than 14%, despite (or perhaps because of) the fact that interest rates have plunged to multidecade lows. This means the average American family is spending one-seventh of its disposable income simply paying the cost of its debts.
  • It shouldn't be surprising, then, that the net national savings rate has remained below 1% since 2005, and has turned negative during some months.

These unsustainable trends have alarming implications for the U.S. economy, as consumer spending accounts for roughly two-thirds of the nation's economic activity, as well as for the retirement prospects of most Americans.

Are you wealthy?
The Millionaire Next Door has a simple test to calculate what your net worth should be right now:

"Multiply your age times your realized pre-tax annual household income from all sources except inheritances. Divide by 10. This, less any inherited wealth, is what your net worth should be."

So, if you're 40 years old and earn $95,000 in salary and $5,000 from investments pre-tax, then your net worth should be $400,000 (40 times 100,000 divided by 10). If this test shows you're an "under accumulator of wealth," then you might want to think hard about making some changes.

Money-saving tips
Assuming that your boss would take a dim view of a demand to immediately increase your salary, and given that job-hopping in this economic climate is unlikely to lead to higher pay, the key lever for increasing your savings is to cut expenses. There are two ways to do this: Consume less or pay less for what you consume. Let me share a few tips on paying less. (This is by no means a comprehensive list; there are countless websites and books dedicated to money-saving ideas.):

  • If your mortgage is more than a couple of years old, look into refinancing to take advantage of mortgage rates that remain near all-time lows.
  • Pay off high-interest debt such as credit cards, or at least shift the balance to teaser rates on new cards until you can do so.
  • Buy generic rather than branded products. I'll admit that I have my brand loyalties, but in general, why pay for big advertising budgets and fat profit margins? To save 20%, 40%, or even 60%, I'm willing to give a generic product a try -- and more often than not, I find that I'm pleasantly surprised.
  • Buy on eBay. No, I'm not your stereotypical eBay junkie, buying and selling trinkets and collectibles; nor do I have the patience for auctions. Instead, I buy a range of products, almost always new (or at least factory refurbished) and at fixed prices. I've purchased lots of things there, including a printer, toner cartridges, a kids' game, a Sony PlayStation (not for me, unfortunately!), a video camera, and an inflatable air mattress. I always shop around and estimate I save 20%, on average, by buying on eBay. There's some risk of unscrupulous sellers, but if you buy only from highly rated sellers, you should be OK. I've never had a problem.
  • Shop at Costco. I agree with Berkshire Hathaway vice chairman and Costco board member Charlie Munger, who once said, "Costco is God's gift to consumers." It has lower gross margins than competitors like Wal-Mart and Home Depot, minimizing markups, and it can generally buy for less by carrying only a limited number of products.
  • If you travel quite a bit, the Web offers amazing bargains. I stopped using a travel agent years ago and instead use Orbitz, Expedia, and Travelocity regularly. But my favorite travel site is Hotwire, which is like priceline, but without the annoying auction process. For example, I once took a trip to Las Vegas and needed a hotel on short notice. Hotwire offered me a room at a five-star hotel on the Strip for $99/night, but -- here's the catch -- I didn't know which one. But for $99, I didn't care! (The Venetian was over the top, by the way.)

The key to accumulating wealth is to consistently spend less than you earn over time. How obvious and simple in concept -- yet difficult in practice!

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