Tag Archives: passive income

Three Lessons from The Millionaire Next Door

The Millionaire Next Door is my favorite personal finance book because of three life-changing lessons it imparts, all supported by mountains of research data gathered and analyzed by two professors, Thomas Stanley and William Danko.  These lessons provided me with a financial enlightenment when I was first learning the basics of personal finance, and I suspect many of you will find at least one of them encouraging, challenging, or both.  These lessons taught me to have a new attitude regarding personal finance, and I hope they do the same for you or your loved ones.

Lesson 1:  The majority of millionaires differ radically from what the media and marketers have you believe.

I grew up on a steady diet of TV and, as you know, advertisers and marketers feed you a stream of images and depicting what the rich are supposed to look like.  Of course, their message equates buying their products and increasing consumption with living like a millionaire.  The Millionaire Next Door shatters the notion that the average millionaire consumes the latest and greatest.

In reality, the average millionaire lives a nondescript life and lives in an average neighborhood. This is logical, as over-consuming would lead one to have less money to save an invest.  Stanley and Danko acknowledge that deca-millionaires, the extremely rich, can afford to consume and live up to the images portrayed by advertisers, but this segment of the population is extremely small.  You are more likely to find the ex-millionaire who has spent their fortune away than you are to find a deca-millionaire who can afford to live an extravagant lifestyle.

Lesson 2:  You will not acquire financial independence as long as your sole source of income involves trading time for money.

Many Americans grow up with the idea that working an 8-to-5 is the only way to pay for life. This mentality is one I grew up with and fails to consider what happens if injury, chronic illness, or another circumstance interrupts your employment.  More importantly, this mentality forgoes any consideration of financial independence, as it assumes one must be an employee their entire life in order to sustain a lifestyle.

You will never acquire financial independence without acquiring assets that appreciate without realized income.

-The Millionaire Next Door

Having assets (savings, investments, businesses, etc.) work for you allows you to achieve financial independence as these assets working for you reduce or remove your dependence on realized income (income you earn via employment).  The more assets you have working for you, the more likely you are to achieve financial independence more quickly.  Think of Dave Ramsey’s debt snowball here, but instead of debt, consider an “asset snowball.”

Lesson 3:  The American dream is alive and well.

We’ve all heard in the media many times that it’s impossible for the little man to get ahead, with stagnant wages, a tepid economy, and any number of other reasons.  The Millionaire Next Door provides all Americans with hope:  The vast majority of millionaires are first generation millionaires, having built their fortunes without the benefit of an inheritance.  That’s right, most people who become millionaires are not trust fund babies and do not have a leg up on the rest of us.  The majority of them live below their means, save, and then invest their way to wealth. The American dream is indeed alive!

Great Personal Finance Podcasts

One of my favorite things to do on long drives is listen to personal finance podcasts.  There are a handful that I have found (so far) to be better than the rest:

My favorite podcast is Afford Anything with host Paula Pant, as she combines an entertaining delivery with great guest speakers.  Paula encourages listeners to both increase their incomes while decreasing their expenses (increasing the “gap”).  Her focus on increasing income differentiates her from many, many other personal finance bloggers who put a great focus on limiting expenses and frugality.  I certainly think both are important, but Paula’s focus on making the gap bigger blows past the flawed binary view on many blogs that we should focus on either increasing income or reducing expenses, but not both.  Paula provides a ton of insight, too, into real estate investing.  I definitely, definitely recommend the Afford Anything podcast.

The Mad Fientist podcast focuses on reaching financial independence.  The Mad Fientist provides some original (to me) ideas:  How to use a health savings account (HSA) as a “super IRA” account; how to minimize taxes when investing in retirement accounts.

The Dave Ramsey Show podcast is targeted more toward people trying to get their financial house in order, but it is still very motivational.  Dave Ramsey releases three hours of the show every weekday, so there’s plenty to listen to.  My favorite segments are Dave’s millionaire theme hours, where millionaires are interviewed and insights are provided into their spending, saving, and investing habits.

Grow Your Retirement Portfolio with Dividends

In the past, I typically looked at four criteria to evaluate mutual funds for my retirement portfolio:

  • Asset Allocation – The asset classes (i.e., stocks, bonds, cash, etc.) I have chosen to invest in based on my timeline and risk tolerance.  Since retirement is in the distant future, I’m willing to incur more risk in seeking higher returns.  For me this means a portfolio that is heavy with stock funds.
  • Rate of Return – The higher this number is, the better.  I look at rates of return over large periods of time (five, ten, twenty year windows) since I have a long time until I retire.  Also, I compare rates of return with mutual funds in the same class (small-cap, mid-cap, international, etc.), with the goal of choosing a relatively better performing fund if I have the ability to choose from multiple funds within the same class.
  • Expense Ratio – The lower this number is, the better.  Expense ratios, measured as a percentage of your investment, track what it costs an investment organization to run a mutual fund.  If I am able to select from multiple funds within the same class and the funds have relatively similar rates of return, I choose the fund with the lowest expense ratio.  The lower the expense ratio, the more money you get to line your own, rather than somebody else’s, pockets.
  • Morningstar Rating – This rating measures how a mutual fund has performed relative to other funds in the same class.  Mutual funds are rated on a scale of five stars- this helps you to gauge whether a fund you’re selecting is a bad performer.  If a fund has one star, it’s in the bottom 10% of its class- stay away.  The next four stars chart the next best 22.5%, 35%, 22.5%, and 10% of performers.

This January, after evaluating the performance of my mutual funds, I discovered another criteria with which to evaluate mutual funds and stumbled across something that caused my balance to grow more than I expected:  dividends.  Dividends are company earnings that a given company can choose to distribute to its shareholders.  Not all companies distribute dividends, as a dividend distribution requires that companies have surplus cash.  Dividends are generally distributed once, twice, or four times a year and a company may choose to increase or decrease dividend payments, or may choose to start or stop issuing dividends according to the wishes of its leadership.  Note that dividend payments are included in a mutual fund’s rate of return, so use dividend yields as only one criteria when choosing to invest.

From December 2011 to January 2012, I noticed one of my mutual fund balances had increased by several hundred dollars, equivalent to slightly more than 3% of my previous balance.  My initial thought was:  “Wow, I wasn’t expecting this!”  I then became curious how to calculate this amount and how I might calculate future dividend payments.  Using finance.yahoo.com, I plugged in the ticker symbol associated with the mutual fund (FFFFX in this case).  I then went to the “Historical Prices” page and selected “Dividends Only” and clicked “Get Prices”. For the dividend issued on December 29, 2011, you see “0.25 Dividend”, which means I was given a dividend of 25 cents per share. To use a round number, let’s assume I started December 29 with 1,000 shares at an opening value of $7.36 per share, which translates to $7,360 total in FFFFX.  The 25 cent dividend was then multiplied by my 1,000 shares, for earnings of $250.  Rather than only experiencing an increase in share price, I acquired 33.97 additional shares, which will allow future dividend payments to grow, as future dividend payments will be calculated based on the 1,033.97  shares I hold rather than the original 1,000 shares.

A key takeaway:  Reinvest dividend payments.  This will allow for future dividend payments to multiply on top of previous dividend payments.  For long-term buy and hold investors, in addition to regular contributions, time, and compounding interest, dividends are an additional tool you can use to grow your retirement portfolio.

Compounding Interest – Why You Should Start Saving Now

My friend Lisa called me on tax day this year for savings advice and wanted answers regarding whether to open an IRA, how much to put in savings, and several other questions aimed at “let’s put together my financial portfolio on this phone call.”  I gave her my best shot with the caveat that financial decisions are more than a financial bottom line.  “Will you sleep well at night” is a question I posed frequently on the phone call and is a question I use to gauge my own decisions.

One piece of advice I did give Lisa is this:  Start saving now.  She retorted that she is not making very much money currently.  I suggested putting away at least a modest amount ($50 or $100) monthly to start.  Here’s why.

Money Down the Drain, Money at Rest, and Money at Work

Food, clothing, a roof over our heads.  We all have needs that we must provide for.  Day to day life, though, often causes our “wants” to creep into what seem like needs.  The morning latte, after work happy hour, and premium cable TV subscription go unquestioned and two hundred dollars are gone from the monthly paycheck.  This is money that goes to line somebody else’s pocket.  Sure, these expenses can bring us pleasure, but they are also dollars that are no longer in your wallet and can’t be used for important purchases (buying a house, car, engagement ring, etc.) or for major life events (college, retirement, etc.).  A timeline for these dollars and their value to you in the future can be summarized as follows:

Expense Amount 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$200 $0 $0 $0 $0 $0

An alternative is to pay yourself these $200 every month:

Amount Saved Monthly 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$200 $2,400 $12,000 $24,000 $48,000 $72,00

As you can see, a little discipline now can produce large rewards later.  What was a daily latte, a few drinks, or cable TV can turn into a significant charitable gift, a tuition payment, or a car.

Although these numbers are large, these same dollars can grow even larger.  Putting money to work for you via the power of time and compounding interest allows you to significantly increase your savings.  The following are examples of what a few amounts saved monthly can turn into when deposited in a savings account that yields .8% APY, a standard going rate as of 6/10/2012:

Amount Saved Monthly 1 Year From Now 5 Years From Now 10 Years From Now 20 Years From Now 30 Years From Now
$50  $602.61  $3,601.81  $6,248.53  $13,017.30  $20,349.62
$100  $1,205.21  $6,123.62  $12,497.05  $26,034.59  $40,699.24
$200  $2,410.43  $12,247.23  $24,994.11  $52,069.18  $81,398.48

The Math Behind the Scenes

Note how putting away $200 a month for 30 years will allow you to save $72,000.  Introduce a relatively low interest rate like .8% and you accumulate $81,398.48 over 30 years, with $11,398.48 of that amount generated passively (i.e., without you lifting a finger).  Here’s how the $11,398.48 is generated.

A year after you decide to put away $200 a month into your savings account, you’ll have an extra $10.43 in your account, for a total of $2410.43.  So you made an extra $10.43- big deal, right?  At the end of year two, not only will you earn the .8% interest on $4,800 ($200 x 24 months) principal you saved, but you will also earn interest on the previous year’s interest.  At the end of year two, you will have a total of $4,840.21, with $40.21 of that being earned interest.  Should you continue to put away the $200 each month for 30 years, assuming a static interest rate of .8%, you will reach the $81,398.48 figure, with $11,398.48 in earned interest.

Note that my calculations are based on interest compounded monthly with additions made at the start of each compounding period.  Different banks will have different frequencies of compounding and different frequencies of posting, so keep this in mind when you start plugging away at online compounding interest calculators, as these variables will affect your overall savings.

Interest Rates and Time

Interest rates and time are key in passively growing your hard-earned cash.  The tables above also illustrate the power of time.  In a future post, I’ll explore other methods of saving that can allow you to grow your savings even faster over the same periods of time.