{"id":7646,"date":"2018-11-26T04:59:47","date_gmt":"2018-11-26T12:59:47","guid":{"rendered":"http:\/\/evergreensmallbusiness.com\/?p=7646"},"modified":"2018-11-26T06:40:11","modified_gmt":"2018-11-26T14:40:11","slug":"defending-millionaire-next-door-theory-what-stanleys-critics-got-wrong","status":"publish","type":"post","link":"https:\/\/evergreensmallbusiness.com\/defending-millionaire-next-door-theory-what-stanleys-critics-got-wrong\/","title":{"rendered":"Defending \u201cMillionaire Next Door\u201d Theory: What Stanley\u2019s Critics Got Wrong"},"content":{"rendered":"

\"Pile<\/a>I recently read The Next Millionaire Next Door<\/cite>, the latest book in the \u201cMillionaire Next Door\u201d series started by Thomas Stanley and William Danko more than two decades ago.<\/p>\n

Note:<\/strong> Stanley died in 2015, killed by a drunk driver. His daughter, Sarah Stanley Fallow wrote the newest \u201cMillionaire Next Door\u201d book, in part by adapting blog posts and other writings from her dad and in part to share new research.<\/p>\n

The new book caused me to re-read a couple of the old books in the series. And then that reading caused me to look again at the criticism some leveled at Stanley and the book series.<\/p>\n

At about that point I figured I could, and should, do a defense of Stanley. Because for the most part, the old criticisms no longer withstand close scrutiny.<\/p>\n

The Original Millionaire Next Door<\/h2>\n

The original Millionaire Next Door book broke new ground by presenting and discussing research that surprised nearly everyone.<\/p>\n

Stanley and Danko, for example, pointed out that most millionaires don\u2019t drive luxury cars or own big houses. Rather, they drive middle-class American-made cars and trucks. And they live in middle-class neighborhoods. Hence, the first book\u2019s title, \u201cThe Millionaire Next Door.\u201d<\/p>\n

Another surprise? The largest category of millionaires own and operate small businesses.<\/p>\n

A good way to summarize these insights? People who show discipline in their spending and who earn a good income grow wealthy over time.<\/p>\n

Self-employment and entrepreneurship seem to help people become wealthy.<\/p>\n

Finally, high status occupations like being a physician or attorney may sabotage wealth building because they push people to engage in high consumption.<\/p>\n

Lots of people\u2014me included\u2014loved Stanley\u2019s books. And the successor books (including \u201cThe Millionaire Mind\u201d and \u201cStop Acting Rich\u201d) amplified the original book\u2019s messages.<\/p>\n

However, critics leveled at least three serious criticisms against the authors and the books.<\/p>\n

The criticisms don\u2019t neatly fit together. They amount to a shotgun blast. But the remaining paragraphs of this blog step through the criticisms one by one.<\/p>\n

Note:<\/strong> I have consciously chosen not to link to critics\u2019 blog posts or other online resources. My reasoning here? You and I have no way of knowing whether old criticisms we find represent a critic\u2019s current thinking. Critics may have updated their thinking for studies like those I reference here. If you do want to find these criticisms, however, you can easily Google or Bing on a phrase like \u201cMillionaire Next Door survivorship bias.\u201d<\/p>\n

Criticism #1: Statistics Reflect Survivorship Bias<\/h2>\n

The most serious criticism? That the books\u2019 conclusions reflect survivorship bias.<\/p>\n

You maybe know this already, but survivorship bias describes errors like looking at the winners to determine your chance of winning. For example, you or I looking at Powerball Lottery winners to \u201csize up\u201d the chances we might have of winning a lottery.<\/p>\n

Note:<\/strong> Wikipedia provides a more precise discussion of survivorship bias here.<\/a><\/p>\n

Clearly that doesn\u2019t work. Nearly everyone who plays the Powerball Lottery, for example, loses.<\/p>\n

The concern with Stanley\u2019s work and books: is something similar going on?<\/p>\n

For example, maybe self-employed folks and entrepreneurs do represent the largest category of millionaires.<\/p>\n

But maybe these folks are simply the people who\u2019ve won the entrepreneurial lottery. Maybe most people playing the entrepreneurial lottery actually lose.<\/p>\n

You see the critics\u2019 point.<\/p>\n

Rebuttal of Survivorship Bias Criticism<\/h2>\n

Fortunately, since the first \u201cMillionaire Next Door\u201d book, researchers have looked at what longitudinal surveys say about self-employment and entrepreneurship.<\/p>\n

Note:<\/strong> A longitudinal survey looks at the same group of individuals over long stretches of time. A longitudinal survey, for example, could explore how regularly playing state lotteries over decades impacts one\u2019s net worth.<\/p>\n

And these surveys strengthen Stanley\u2019s research conclusions.<\/p>\n

For example, in a paper entitled Self-employment, Entrepreneurship and the NLSY79<\/a>, economics professor Robert Fairlie looked closely at data from the Bureau of Labor Statistics\u2019 1979 cohort of National Longitudinal Survey of Youth (NLSY79). Fairle wanted to see how self-employment affects someone\u2019s income over the long run.<\/p>\n

Professor Fairle\u2019s conclusion? Self-employed people make more money.<\/p>\n

Updating Fairle\u2019s numbers for inflation, for example, a self-employed male in the longitudinal survey averaged about $73,000 in annual earnings while a \u201cwage-employed\u201d male averaged about $53,000 in annual earnings.<\/p>\n

Another longer research paper based on the 1979 and 1997 cohorts of the same longitudinal survey delivers complementary findings.<\/p>\n

In A Longitudinal Analysis of Early Self-employment in the NLSYs<\/a>, Abe, Betesh and Datta estimate that as compared to traditional employment, each additional year of self-employment increases a family\u2019s annual income by around $780 a year and its wealth by around $11,700 .<\/p>\n

Ten years of self-employment, for example, increases a family’s annual income by about $7,800 (10 times $780) and a family’s wealth by about $117,000 (10 times $11,700).<\/p>\n

Clearly, then, small business ownership bumps income and net worth. And logically small business owners who also display financial discipline and common sense will often enjoy big bumps in net worth.<\/p>\n

Note:<\/strong>\u00a0We’ve blogged before about what IRS data says about millionaires. That data nicely meshes with Stanley’s research: Smart Wealth Strategies of the Top One Percent.<\/a><\/p>\n

Criticism #2: Research Ignores Business Failure Statistics<\/h2>\n

A second criticism half connected to the survivorship basis issue. Critics pointed to the well-known 50% business failure rate statistic.<\/p>\n

The relevant Bureau of Labor Statistics data appears here.<\/a>\u00a0And the usual way the failure rate gets described is, 50% of new businesses fail within 5 years.<\/p>\n

In terms of the \u201cMillionaire Next Door,\u201d the business failure rate criticism says surely<\/em> self-employment and entrepreneurship can\u2019t work as a strategy when half the businesses started fail\u2026 Yikes!<\/p>\n

Rebuttal of Business Failure Rate Criticism<\/h2>\n

But probably a good answer exists for this good question: The economy doesn\u2019t limit an entrepreneur to a single startup.<\/p>\n

Accordingly, if someone makes several attempts, the odds that the entrepreneur ends up with a success grows exponentially.<\/p>\n

Someone who makes three attempts, each with a 50% chance of failure, for example, sees only a 12.5% chance of overall failure:<\/p>\n

50% times 50% times 50% equals 12.5%.<\/p>\n

Another way to frame this reality: The entrepreneur\u2019s pursuit of a success roughly resembles that of a worker interviewing for jobs.<\/p>\n

Think about this for a minute: Say a worker\u2019s chance of an interview turning into a job equals 50%. Does this mean the worker\u2019s prospect of getting a new job equals 50%?<\/p>\n

Hopefully not. Hopefully someone who wants a new job continues his or her search if he or she fails to convert the first interview into a job.<\/p>\n

Entrepreneurs work the same way. Research indicates that entrepreneurs, like workers looking for a good job, make multiple attempts.<\/p>\n

For example, the Kauffman Foundation in its report Anatomy of a Entrepreneur: Making of a Successful Entrepreneur<\/a>\u00a0describes a group of roughly 500 successful entrepreneurs. In their sample, the average entrepreneur makes 2.3 attempts.<\/p>\n

In summary, then, one can\u2019t simplistically derive entrepreneur success rates from the failure rates for individual ventures.<\/p>\n

Note:<\/strong> If you sometimes ponder starting a business but then stop yourself, thinking \u201coh my gosh of course the risks are way too high,\u201d you might find this post interesting: Odds of Succeeding in Small Business.<\/a><\/p>\n

Criticism #3: Financial Success Reflects Social Privilege<\/h2>\n

One other criticism to mention in light of the longitudinal studies: Some critics of the \u201cMillionaire Next Door\u201d books worried that the entrepreneur\u2019s business success flowed from an entrepreneur\u2019s personal wealth or the entrepreneur\u2019s extended family\u2019s wealth.<\/p>\n

In other words, maybe self-employment and entrepreneurship work great for people\u2014but most people don\u2019t actually get the opportunity.<\/p>\n

This anxiety sometimes also connected to concerns about growing income and wealth inequality.<\/p>\n

One critic, around the time of the 2012 presidential election, pointed to Mitt Romney\u2019s private equity success as a prime example.<\/p>\n

Quite honestly? I worried this charge would hold up. It makes intuitive sense.<\/p>\n

Rebuttal of the Social Privilege Criticism<\/h2>\n

But both longitudinal survey studies mentioned earlier looked at this issue too. And both say the entrepreneur\u2019s wealth prior to his or her business doesn\u2019t matter very much at all.<\/p>\n

The Abe, Betesh, and Datta research, for example, says this:<\/p>\n

The estimation results show that the effects of financial resources are positive and significant, but the effect is so small that an increase in $1,000 or even $100,000 does not make any consequential difference, controlling for other factors, in the probability of being self-employed.<\/p><\/blockquote>\n

That\u2019s interesting. And it should be comforting.<\/p>\n

But maybe one shouldn\u2019t actually be surprised by this. The wealthy often aren\u2019t in the process of becoming more wealthy but rather less wealthy\u2014something we\u2019ve discussed at this blog before when pointing to longitudinal studies of high income individuals (see, for example, Financial Planning for the Top One Percent.<\/a> and The Rich Get Poorer: the Myth of Dynastic Wealth.<\/a>)<\/p>\n

Like the other criticisms, then, this criticism also fails to withstand closer scrutiny. Though to be fair, let me mention that some earlier research says access to capital matters. For example, economics professors David Blanchflower and Andrew Oswald in their paper What Makes an Entrepreneur?<\/a> present data from the United Kingdom. That data show modest gifts and inheritances from family (so a few thousand pounds) boost the chance someone becomes self-employed.<\/p>\n

Two Final Comments<\/h2>\n

I want to end this blog post with a conciliatory remark concerning the critics of the Millionaire Next Door and then a caution based on something disturbing that shows up in the longitudinal surveys.<\/p>\n

First the conciliatory remark: The longitudinal-survey-based studies referenced above were often not available when people first criticized Stanley for things like survivorship bias. The first book in the \u201cMillionaire Next Door\u201d series, for example, appeared in the mid-1990s and the longitudinal survey studies referenced earlier appeared a decade or more later.<\/p>\n

Accordingly, I think we need to be civil here. No need for rock throwing. The critics moved the discussion forward by raising these issues. Their criticisms may have lead to the research that refuted their criticisms and solidified Stanley\u2019s, Danko\u2019s and Fallow\u2019s ideas.<\/p>\n

And now a caution about something else that shows up in the longitudinal studies. Disturbingly, Blacks and Hispanics pursue self-employment and entrepreneurship at rates much lower than Whites. Very possibly, maybe even probably I am sorry to report, these lower self-employment and entrepreneurship rates reflect systematic racism.<\/p>\n

This blog post doesn\u2019t cover political topics\u2014other outlets exist for having those discussions. However, let me say that in our CPA firm we have the honor and privilege of working with a diverse group of successful small businesses and their owners. And we can report, happily, that anyone can enjoy entrepreneurial success. Furthermore, let\u2019s all remember (as citizens and consumers) that self-employment and entrepreneurship helps us all out by providing products and services we want and by providing employment to our neighbors and family.<\/p>\n

Don’t Miss the Millionaire Next Door Business Plan<\/h2>\n

Next week, as another “test” of the whole “Millionaire Next Door” theory, we look at developing a “Millionaire Next Door” business plan.<\/p>\n

You may want to subscribe to our newsletter to make sure you don’t miss that.
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