Friday, 11 May 2007

starting a business will not make you rich

I've often read comments on other personal finance blogs that essentially state that the best way to generate wealth is to start your own business. Undoubtedly there are people who have successfully made a lot of money in this way - look at Microsoft, Apple, Yahoo and Google for very modern examples. The Millionaire Next Door (which I haven't yet read) is cited as evidence for the success of this method towards wealth as one of the facts which is commonly pulled from the site is that many of the millionaires interviewed for the book own their own businesses.

As you can probably guess from the title of this post, I think that this argument is flawed. I actually think that its quite hard to become wealthy through working for yourself. When you start off, you are likely to have a negative cashflow for a while as you try to get your business off the ground. You'll probably need to work long hours for a long time paying yourself at wages that are effectively much less than the minimum wage. Your business is likely to fail within ten years, with luck this might not leave you out of pocket, but not everyone can have all the luck all the time. In any case, you need a lot of time and start-up capital to build a business that will truly give a good rate of return - not that many people have both on their side.

You could argue that if you are working for yourself you are more likely to be motivated and so will generate more money. That might be true, but there is also the possiblity that you will be more risk-averse than you need to be because its your own money at stake. Its certainly the case that when you are working for yourself, any money that is made through your efforts goes into your pocket. Making an effort, however, doesn't necessarily lead to making money.

My final point, is that getting rich isn't really about the money you make, its about the money you keep. The foundation of true monetary wealth is likely to be a well diversified portfolio. If all your money is invested in your business, then that the very definition of poor diversification. The simple way to wealth is to spend less than you make and invest the difference. This is probably easier to do with a regular salary than with your own business.

By all means, start your own business if you think it will make you happier, but don't think that it is a path to wealth.


Flexo said...

Books like The Millionaire Next Door that profess that the way to wealth is starting your own business suffer from survivorship bias... the books never tell you that most businesses fail... they just share the success stories and ignoring the statistics that don't agree.

On the other hand, investing in a diversified index fund, while providing the best return for the risk, will never really make you wealthy either unless you start very early, thanks to inflation. Yeah, you might be a millionaire in 30 years, but 30 years from now $1,000,000 won't get you a whole lot of "stuff."

moneymonk said...

I feel there are 4 ways to become rich on your own:

capital markets investing
CEO of a fortune 500 company
Real Estate

unfortunely, they can all break you as well.

Bottom line everything has risk, use your own due diligence.

Ben said...

I agree with your title, simply starting a business won't make you rich. It's what you put into the business that can make you wealthy.

The June edition of Smart Money Magazine has an interesting article on this topic entitled "How to Make $5 Million".

plonkee said...

Certainly the number of people who start a business and go on to become bilionaires is so small that you should probably ignore it.

I also think (without any particular evidence) that its quite likely that just investing in a diversified index fund has a higher expected wealth value, as the chance of failing is so much less than the chance of a small business failing.

Of course, all this means is that individual results may vary.

Joe said...

9 out of ten businesses fail because 9 out of ten people in the world ard idiots. I believe it is possible to become rich if business is your forte and you love to do it (like me). A well diversified portfolio is definately the way to go (with or without a business). You're right about inflation taking away from you business BUT don't forget about compound interest. You can reinvest into you're business and grow rapidly. Excellent post! Thanks for shattering our dreams lol!

ispf said...

I would not brush off "starting a business" that easily. Maybe it won't make you rich the first time around, but if you keep trying and keep learning from your mistakes, then eventually you could succeed.

On a more complementary note to your article, I wouldn't recommend someone to quit their day job to start a business. Start something small on the side and if it clicks, then maybe quit the day job to pursue the business full itme. There are a lot of examples in the blogosphere where people have been successful in this approach. Here is one that I read recently (look at answer to quesiton 3)

Q at $1 Million to My Name said...

I have friends that have started their own businesses are are great success stories. It is a wonderful patch to millions, but not the only one.

briana said...

I think that starting a business *can* make you rich, but that not everyone is suited to entrepreneurship. If you prefer to work for someone else, you shouldn't feel like you have to make yourself into an entrepreneur in order to get ahead financially. While there may be greater potential for riches through owning your own business, I don't think there's anything wrong with slowly increasing your net worth as an employee. As others have said, it's more important to manage the money you do have responsibly, and to be open to opportunities to increase your wealth - an entrepreneur does it through business opportunities, and an employee does it through career advancement.

Amy said...

This seems obvious, but most people don't get it. There's a reason certain occupations or businesses pay millions of dollars, while yours doesn't. It's because to succeed in those areas you either have to be fantastically skilled (like a professional baseball player or a transplant surgeon), put in phenomenal amounts of work (high-powered corporate attorney comes to mind) or get ridiculously lucky (dot com millionaire, real estate investor, slinky inventor).

Most millionaires are some combination of the above, but most millionaires also tend to discount the role that luck played in getting them where they are. So if you're an average joe in most respects, and you're not willing to work twelve to sixteen hour days six or seven days a week, then pretty much the only way you're going to get rich is if you get lucky. And getting lucky is not a life plan.

plonkee said...

Amy said:
...getting lucky is not a life plan.

That is my favourite quote this week. And so very true.