I was recently pleased to note that a Frontline program from
last year (“The Retirement Gamble”) had finally begun to note the virtues of
low-expense-ratio large-market-index index funds. This year, we have Piketty and Saez, who have
finally noticed the importance of wealth rather than merely income in creating
and maintaining the ranks of the rich.
They echo what I wrote in an (unpublished) book on money management for
the rest of us 15 years ago: that while
over the long term (20 years or more) stocks are the best bet, there are two
sets of people who will guarantee that your stock investments will
under-perform: other people (most advisers
and fund managers) and yourself. Index
funds are on auto-pilot; they avoid both sins.
However, what I really had not thought deeply about 15 years
ago was that simply putting half of your money available to invest in a
reasonably diversified stock portfolio (the rest, say, in bonds), above a
certain level of investment “wealth”, will effectively guarantee that you will
get richer and richer relative to everyone else. In other words, unless you manage to spend so
outrageously that you go below that minimum amount (despite what you think,
it’s not easy), your net worth will over any 20-year period grow at such a
rate, on average, that it will double every 8-15 years. $5 million today? If you go for an S&P 500 index fund from
Vanguard with a 0.1% expense ratio, it will be $10 million in 2022, $20 million
in 2030, and $40 million in 2038, or about when you’re ready to pack it in if
you’re 60 now – and that’s after inflation.
And those who don’t invest in stocks (reasonably
diversified) and are lucky enough to avoid a shark like Bernie Madoff (as the
late Robin Williams remarked, “Was the name not a clue?”) – i.e., those who
aren’t rich – will find it much harder to get rich, at the least. Bonds? 1-2% above inflation, often less than enough
to cover living expenses. Houses? 2%
above inflation at best, because all those fancy sales figures don’t show the
large amount you must spend on upkeep to keep them usable. Anything else? Historically, either worse, or the equivalent
of hoping to “win the lottery”.
Rich Person’s Game
So here’s how it works, for a particular rich person – one,
say, starting with $3 million in the Vanguard index fund referenced above, and
with a net wage income of, say, $57,000.
That index fund, on average (actually, something called the geometric
mean), generates about 10.85% per year before inflation, about 8.6% after. About 2.25% of this comes from dividends, or
$67,500, on which you pay 15% tax, or about $10,000, leaving you with $57,000
(net return about 8.3%). Now let’s
assume that you live on your income for the first year. The next year, you have about $3.25 million. What about capital gains? The S& P fund is superb for avoiding most
of those – the smallest stocks in the index are the ones that get bought and
sold (enter or leave the S&P 500). And you’re still paying only 15-20% in
taxes on those.
8 years from when you start (when you’ve doubled your
money), your take from your dividends has reached $114,000. However, you’re still getting a net of about
8.3% from your investment, year after year.
Over time, the amount of capital gains gets slightly larger, but –
here’s the shocking kicker – after you die, the “cost basis” from which capital
gains get computed goes to the stocks’ current value, which means that capital
gains of anything that gets sold after that goes back to about $0 again. How could Mitt Romney pay 10% of his income in
taxes? 1/3 of the income was dividends,
and 2/3 was sale of stocks with effectively 0% capital gains tax. I don’t know
if that’s what happened, but that’s how it could be done.
The most amazing thing about this is that you can up the
taxes, assume that the rich person is sub-optimally investing by a large
amount, and still, the net worth will keep marching on up – by less, but still
by enough to handle a lot of wasted spending.
At $6 million, you can spend money on four $100,000 cars per year and
your net worth will still march on upwards.
At $12 million, you can afford an $800,000 second house, cash up front,
and you will still be gaining. You can
give away 3% to an active manager of a fund in a 401(k), and still be doing
well. You could be taxed on your wage
income at 90%, or your dividends and capital gains at 50%, and you’re still doing
excellently, increasing your net worth more and more.
In fact, many rich people do invest poorly. They go for active funds, investment
advisors, hedge funds (performs less well than index funds over time, latest
figures show, and the fund is taking perhaps 80% of the profit), far too much
in the way of bonds (by some figures, about 50%), and plenty of fads. Piketty’s figures seem to suggest that
they’re no better than the few non-rich who have to use 401(k)s with their
rigid menu of non-index funds and high fees up and down the line (estimates are
it costs us 2-4 %). The difference is,
the not rich are trying to reach that magic $3 million, and using some of the investments
for living expenses, because they have to.
Even at $500,000 in investment wealth, you’re still in real danger of
getting poorer. But the rich get richer.
And the higher you go, the less job income matters. Don’t like the CEO’s $10-million-per-year
package, 400 times the corporate median wage?
If that CEO is a billionaire, he or she is earning $80 million a year
just from investments (if it’s our index fund example), or $40 million if he or
she is the typical lousy investor.
And so, what the CEO earns (most of the rich are CEOs,
including CEOs of financial firms) is not a case of the rich getting richer;
it’s a case of the head of the firm finding a way to enter the charmed circle
of the rich, quickly. Controlling
inequality is not a matter of controlling income from work; it’s primarily a
matter of controlling the amount the invested rich reap from their stock
investments compared to the non-rich.
Why Even the Best Don’t Seem to Fully Get It
Most commentary about today’s increasing imbalances in
income and wealth seems to fall into three categories. The first category is those who justify these
imbalances as somehow reflecting the value of the individual who is becoming
richer and richer. Of what added value
to society is an individual who simply sits on an investment and watches it
grow (remember, that’s how today’s rich are increasing their wealth)? Anyone can do that. No, to me those who justify the imbalances are
the equivalents of the prostitute in one of Douglas Adams’ Hitchhiker books,
whose sole source of income is assuring the rich that they really do deserve
all that money, and those who criticize them are just meanies.
The second class of commentators are aware that there’s a
problem, but seem to think that income taxes are the solution. Rather, high income taxes slow the flow of
new rich into the charmed circle, but have very little effect on those who have
already joined – they get most of their money through dividends and stock
appreciation.
The third set of commentators – I would include Paul Krugman
and Piketty and Saez in this class – realize that there’s a problem, and that
it’s connected to wealth. However, the
same sophistication in economics and understanding of data collected about the
aggregate within a nation that allows them to see the results of the rich
getting richer right now, seems to fail them when they actually consider the
connection between national trends and the individual case.
In the case of Piketty and his better critics, the question
focused on is whether “r-g” will continue – at a guess, whether the rich can
continue to gain a larger piece of the pie indefinitely. But that’s a question with an easy
answer: as long as stock markets continue
to deliver outsized returns over the long term, as they have done for at least
the last 95 years, and taxes and very severe depressions do not shrink wealth
to the point where many fall out of the charmed circle (as seems to have
happened in the forty years during and after the Great Depression), then the
rich will indeed get richer. And yet,
looking at things from the perspective of national economies, the idea that the
rich can have a bigger slice of the pie for a very long time seems
counterintuitive. And so, the idea of
higher income taxes and estate taxes is the focus, while a wealth tax such as
the one in France is barely mentioned and assumed not to be an effective path
to reversing wealth and hence income inequality.
To my mind, one of the main reasons for this “difficulty in
getting it” is the fact that we don’t see most of the appreciation of stock in
the data – it shows up only as capital gains when the stock is sold, and even
those are far less than the real income appreciation. Remember, you first pay out of dividends, and
then take a little capital gains when the index fund has to rebalance, and when
you die the cost basis is reset and when your inheritor sells it seems as if
there has been little increase in the stock.
So, over 30 years your wealth may multiply by 8 times and yet, going by
dividend and capital gains figures, it has not yet doubled.
There is, by the way, one really strange way that we also
underestimate the wealth underlying capital gains reporting. Let us suppose that we arbitrarily decide to
sell 0.8% of our stocks every year.
Remember, each year the value of the stocks goes up by 8+ %, so for the
first ten years, we are paying capital gains on our first year’s gain in
stocks, and by the end of the 20th year, we are still paying capital
gains on the second year’s gain.
However, during the 20 years, we have seen inflation that has
effectively reduced the value of the money we are paying. So, at about 3.5% inflation, that payment in
the 20th year, in real terms, is about ½ of what it would have been
if we had paid at the end of the first year.
This, by the way, is another way that the rich reduce their taxes in
real terms.
Now, if at the time of your death you had to sell all your
stocks, all those capital gains savings on delayed capital gains tax payment
would be reversed. But you don’t – you
will probably have to sell relatively little of the stock. And so, the real cost of the capital gains to
your heir keeps getting smaller, and smaller, and the amount of actual wealth
relative to the amount of capital gains reported keeps getting larger and
larger …
The Personal and Global Bottom Line
I see two take-aways from this analysis of the investment
rich getting richer. The first is personal: whoever you are, if you aren’t rich by my
definition, get somehow to a net worth of at least $1.5-$3 million that
includes at least $1.5-$3 million in diversified stocks. Then, by the method I’ve outlined, you should
be set for life. Note that this doesn’t
include expenses from your support for other people, such as a spouse and
children – ideally, they too at some point in their lives should reach
equivalent wealth, so they are set no matter what happens to you. Yes, I realize that for most this is very
hard to do, and that the kind of fees we see out there when you do a 401(k) or
an actively-managed fund or get investment advice or try to do stock investing
yourself make it much, much harder. All
of this discussion of how to optimize your investments is in my unpublished
book of 15 years ago.
My second take-away applies in the area of global economic policy. Piketty and Saez have masterfully shown how,
with the exception of the period after the Great Depression, income and wealth
inequality have grown steadily over at least the last 150 years. Unless policy deals with the underlying
reason, as I’ve laid it out, that the rich can indeed get richer in relation to
the rest of the world, then policy is very likely to be ineffective. That means serious consideration of a wealth
tax such as the 2% one in France, as long as it applies to stock investments. Personally, I’d make it a 3% tax targeted at
the rich – those who are smart enough to weight their investments heavily in
index funds will continue to grow in wealth, but the majority, whose yield is much
less, should see an almost flat net worth trend.
Of course, you still have to deal with the problem of making
such a tax global, else the rich will just domicile elsewhere. Still, as with other taxes, there are ways of
dealing with this to some extent. If we
wish to get a handle on a problem that makes the global and US economy
underperform and also has very bad effects on the non-rich, we need to target
just exactly why the rich are getting richer, and target our solutions to that
understanding. Here’s hoping we won’t
take decades to do this.
