Your place in the wealth scale

What are the secrets of Australia's millionaires? Or those Australians worth $1.8 million to be more precise – that's the average wealth of more than 30,000 wealthy investors I have been researching at Wealth Benchmarks since January. Here’s what I have discovered:

First. Time is the most important driver of wealth. Successful people create a “virtuous” wealth-building circle of earning, saving and investing and reinvesting. On average the net worth of our wealthy Australians grows about 6% each year, based on income and savings alone (excluding capital growth of investments). Net worth is the value of all assets less debt.

The graphs below show how wealth evolves with age and, importantly, represents a wedge shape (left side) which figuratively divides the fortunes of the more wealthy from the less wealthy with time. This figure is a plot of the net worth of users versus their age, showing the result for the typical or median user (blue circle), the range between the top 25th percentile wealthy and the bottom 75th percentile (blue vertical bar) and the result for the average user (green circle, offset right). The solid black lines forming the wedge shape define the range in net worth for 50% of participants. The dotted line is shown to remind you that 25% are worth more and less than this. I hope you are in the former category!

The typical member of this group, which coincidentally shares the same average net worth of the top 20% of all Australians, becomes a millionaire at age 40 and a double-millionaire at age 55. For our (aspiring) wealthy group, between the ages of 30 and 60 wealth increases at $60,000 and $80,000 a year as evidenced by the sloped lines in the right-hand representation. The lower blue-line estimate is for the typical individual or household (median) and the upper value represents the result for the average. The latter is always higher as a few with significant wealth bring up the average or mean result. If your net worth went up last year more than $80,000 you are above average compared to this group. If it went up above $60,000 you are in the top half of the class.

Time is the most important driver because time is needed for savings to accumulate and investments to compound. The wedge shape shows that it is quite hard for a 30-year-old to break out and became ultra-wealthy at that age (although not impossible particularly for business entrepreneurs). By age 50, a much wider band separates out those who have been prudent spenders, regular savers and investors from those who have not. After this age, wealth either continues to grow, plateaus or declines. It all depends if you are still working and how fast your assets are growing versus what you spend.

Economists and statistician readers would remind me to point out that the study is not a “longitudinal” (it is not the 7up, 14up, 21up – of investing – at least not yet, give us time). I show here the finances of people at different ages at one point in time and the above implies a pathway that younger people follow to become more like those older. This will not be exactly the case as generational effects will play out.

The key message, which is a timeless anecdote about finance, is that we build wealth patiently and purposefully. There is a rich reward for those who get it right.

The role of income

Next in the hierarchy of important wealth drivers is earned income. Perhaps not surprising this is a secondary effect and we observe that wealth doesn’t step up for all unless gross income rises above $200,000 a year. Below this amount, high levels of expenditure mean several fail to take advantage of their moderately high income to build wealth.

One of the best known wealth correlations offered by Dr Thomas Stanley and co-author, in the US 1996 classic The Millionaire Next Door.

Expected Net Worth = Age x Income / 10 (Stanley & Danko 1996)

According to this ratio, net worth, which includes the value of your home, should be equal to your age multiplied by your income divided by 10. For someone aged 35 earning $100,000 a year, their net worth should be $350,000.

I find this does not describe the Australian situation well and further I suspect it always was an oversimplification because it penalises the newly employed 20-year-old on her/his first day of work who is immediately assumed to be worth two-thirds of a 30-year-old (who has worked and saved for a decade and who earns the same salary). Further, it would only be coincidental if this 11-year-old correlation fit Australians as we earn, spend and are taxed differently.

We have identified a correlation between wealth (net worth) and gross income (earned and investment income) for wealthy Australians based on my data as follows:

Expected net worth = 1/4 x income x (age – 20) (Wealth benchmarks™¢)

Statistically this relationship explains about 50% of the variation in the data so far analysed. For a couple aged 40 earning gross income of $150,000 a year, this relationship suggests their expected net worth may be $750,000. This relationship is intuitively more correct as in essence it says net worth is equal to one-quarter of the number of years of income an individual or family has earned since age 20. Age 20 seems reasonable as this is when many start work. (For those of you anxious about your 20, year-old children living at home and not working, maybe you can tell them the clock has started ticking!) The one-quarter factor aligns with a gross savings capacity, which doesn’t seem out of whack with what I observe.

You might wish to calculate this for yourself, based on your age and total gross household income. Don’t forget to include your investment income, which simply could be 5% across all investments regardless of whether they are inside or outside superannuation. The ratio of your actual net worth to your expected net worth we call wealth efficiency. If you are much above 1 or 100% you may be a highly efficient wealth accumulator. If this number is much below 1 or 100% then you might try to understand why or seek expert advice.

The next charts provide two different ways to visualise the relationship between age and income depending on whether you like to see wealth as a three-dimensional mountain peak you climb or are friendly with contour maps.

Of course we wouldn’t expect this to explain everyone’s wealth. For instance, if your income has moved sharply up or down recently then this rule of thumb will be unfair or too generous respectively. This correlation applies mainly for working families, not retirees because their income may fall away after no longer working.

This rule of thumb should prove useful to help answer "Am I on track?" and how efficient one has been converting income into wealth. I have also used this correlation as a diagnostic tool to study other wealth drivers other than income and age.

Investment pathways

Other factors apart from age and income drive financial freedom or impact it. I observe, for example, a marital separation knocks off on average 20% of lifetime wealth. Of particular relevance to readers of Eureka Report is the reward for being a long-term share investor.

The final graph depicts an impressive relationship between the amount of investments held by those over age 50 versus how many years they have been a purposeful share investor. I focus here on this older segment, as this offers a longer history and offers greater opportunity to discern trends. I use net investments as a measure as this pulls out the effect of borrowings that otherwise could inflate what is truly owned. Specifically I asked the question '¦

“What is the approximate number of years you have been actively investing in equities/shares directly or via managed funds? (excluding occasional share purchase or workplace super)”

This figure shows that those who have been investing for more than 20 years – that is, nearly half their lives, have typically accumulated $1.5 million in net investments or twice as much as those who didn’t ($750,000). For more than half of my users this difference is even greater as evidenced by the higher range of values above the median than below. This provides unique evidence that a long-term investment focus can deliver.

Although not shown, this same pattern emerges for those who indicated in separate questions the number of years they have i) been a property investor, ii) used debt for investing and iii) focused on building a business. The latter shows not surprisingly the greatest variability that reinforces that self-employment can be a more uncertain road to wealth. However, the prize for that group is the highest and self-employed individuals in my sample are about twice as wealthy as the employees. The “biggest loser” in this comparison were those people who indicated they did not have an investment focus of any kind.

Investing

Asset allocation is a significant driver of investment return. Overall, I find our wealthy to be growth investors, however, they are clustered into four groups (in order of equity or growth like investment focus):

• Cash only investors (small but nevertheless significant)
• Property rich investors (I classify property as 50:50 growth:income)
• Traditional diversified growth investors (peak have 75% of growth assets)
• All share or business equity investors (equal in size to all cash investors)

About 40% of those I researched are direct residential property investors. Within this group about 40% have one property, 20% two properties and the balance have three or more properties. The average holding is $800,000. Most holdings are outside super and funded with debt. Very few have non-residential direct property (such as a small office or warehouse). Property is a “lumpy” investment and for most of those who choose to invest in direct property, about 75% or more of their total investment allocation becomes dominated by direct property. Some would argue this is a dangerous concentration. There is some evidence that property is “sacrificed” prior to retirement age to fund super and as part of a degearing strategy, although this could be a generational effect. Direct property and related investment debt are most popular between the age of 30 and 60 and of course with higher income earners ($100,000 or above) who earn an appropriate investment deduction through negative gearing.

Shares in listed companies are the most dominant investment class (after cash). Outside of super, 80% hold shares directly and less than half use managed funds to access them. Overall super and non-super portfolio allocation to shares is about 40%, however, this average value includes a nearly equal contribution to direct property, which I know is an averaging effect of those who have with those who don’t. Looking specifically inside superannuation, I see that between 10% and 30% are all-share investors (most focus on Australian shares, and the percentage declines with age and balance, particularly as the important role of diversification is understood). About 70% investors classify their portfolio construction as “growth” or “balanced” construction. The mix shifts with age from more growth to more balanced as you would expect. Investments in super overtake those outside super by about age 55.

Knowing the right asset allocation for you and managing your portfolio to this target is a critically important investment discipline. This work reinforces my suspicion that too many Australian investors neglect this fundamental and focus instead on tactically or ad hoc accumulating shares and other investments.

As noted there are many different pathways to creating and enjoying wealth. Just like for companies, benchmarks along the journey can help people and help professional advisors check their progress and identify opportunities for improvement.

Dr Doug Turek is managing director of Professional Wealth and founder of Wealth Benchmarks. To see how you and your portfolio compare visit www.wealthbenchmarks.com.au. The article is based on a report just released for financial institutions. A book on the topic is due to be released on June 2008.