According to page 8 of Dr. Thomas Stanley’s research in the book “The Millionaire Next Door”, people that are self-employed make up less than 20% of American workers yet they constitute almost 70% of the people that make up the millionaire class in the United States. To break down this self-employed group even more, three out of four of them are actual business owners with the rest of them being accountants, lawyers, and doctors.

This is not simply a coincidence. There is a reason why someone who runs their own business shows up disproportionately at the top of these wealth-building lists. When you run your own business, you are no longer (1) bound by “time” to make money in the way that someone who sells their labor is, and (2) you are the direct beneficiary of all of the company’s gains; when a business experiences 10% growth, it does not mean that all the employees get a 10% raise. It is this difference that explains why it is lucrative to be on the ownership side.

As Stanley goes on to say on page nine, millionaires own “the types of businesses that could be classified as dull-normal. They are welding contractors, auctioneers, rice farmers, owners of mobile-home parks, pest controllers, coin and stamp dealers, and paving contractors.”

To put it in terms that are relatable, imagine that you own a McDonalds franchise out in the clear. No debt on the franchise, and no rent to pay on the underlying land (even among McDonalds franchisees, this would be rare because most of them would make the active choice to try and maximize wealth by owning three franchises that are partially funded by debt than own one outright).

Although it depends on the area, the ownership cost of this franchise would be somewhere around the $1,000,000 mark. Unless it is in a bad or saturated area, it should conservatively generate $150,000 in actual post-tax cash profits for you, the owner of the franchise.

No matter what you do, you are making money. You could take Saturday off, and you will make $410 that day while you are watching movies, attending a kid’s baseball game, or whatever it may turn out to be. If it is a location that is open 24 hours per day, you would wake up $135 richer than you were at the time you went to bed because you were hiring someone else to make hamburgers, coffees, salads, soda, chicken, and egg sandwiches while you were asleep.

You could easily reach a point in your life where going on vacation could make you richer, simply due to the compounding machine that you’ve unleashed. If you went on a two-week trip to Europe, you would become richer during the course of that vacation as long as you kept your spending below $5,740 during that time. That is how a single, lucrative asset can transform your life. In order to make money, you’re no longer bound by your specific hourly labor efforts (i.e. you have to work 10 hours to make $150) but rather, the flow of cash continues even when you aren’t directly working.

And just think about what happens if you take that $125,000 per year and only live off $85,000 of it, using the rest of it buy shares of Coca-Cola, the soft-drink giant that is selling Powerade, Sprite, Coke, and Dr. Coke to your customers like clockwork. In this arrangement, you have basically created a systematic arrangement to buy 1,000 shares of the most powerful, dominant corporation in the world each year. Someone following that wealth prescription for ten years would not only have a McDonalds franchise shooting out $125,000 per year, but would have accumulated $618,337 in Coca-Cola stock that would now be paying out around $17,000 in annual dividends of their own which would be automatically growing at a rate around 8-10% per year. Without even taking into account your own growth at the franchise, you’ve now replaced 13.60% of your franchisee income with Coca-Cola dividends alone. That is why the word “magic” is heavily associated with compounding effects; you find something that gives you regular profits to play with, and suddenly, you can start buying other cash-generating assets that will give you profits of their own as well.  And the next year, you could add a third cash-generating asset that does the same thing. This is how wealth is built.

In the case of the lawyers, doctors, and accountants that made the millionaire’s list, they are able to charge such a high rate for their time that this acts as a countervailing force against the fact that their billing may be bound by their labor. Plus, they can take their excess profits and funnel it into publicly traded business as well; in their case, they are the business.

The point, though, is that building wealth is the product of living below your means. Some of that involves frugality, but the other half of the equation involves growing the amount of money that comes your way. And in order to do that, you need to be active about the process and actually own an asset that “automatically” pays you money on a regular basis. That’s the hard part, but once you get it down, you will find yourself make $1,000 and $2,000 investments each month, and it will be done with much less effort than it took to come up with $100 per month in the early days. That’s the nature of how compounding effects work.

Originally posted 2014-02-10 07:35:23.

Like this general content? Join The Conservative Income Investor on Patreon for discussion of specific stocks!