Unconventional wisdom: Why isn’t everyone rich?
The stock market has been one of the greatest wealth-building machines in history but many investors sabotage themselves.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Why isn’t everyone rich?
It’s the human condition to be average. Its not to be as good as you can be. It’s the human condition to survive. Just get along and be average.
- Nick Saban
The title of this article is the first line in a recent report titled Exponential Wealth: Centuries of Stock and Bond Returns by Roger Ibbotson. And it is worth asking.
We live in an age of democratised capitalism. For most of human history the only way to make money was through labour. But over the last century people had the ability to use their labour to make money while investing a portion of their income to profit from the labour of others.
The report shows the profit engine available to investors. Over the last century $1 invested in US shares resulted in $14,751. Inflation had an impact but purchasing power was still increased by $814 for each dollar invested.
The question the report ponders is why most people haven’t used this exponential wealth engine to get rich. Unlike much of the financial commentary the reasons have little to do with the investments in your portfolio.
What gets in the way of getting rich?
The report outlines several reasons people don’t take advantage of this exponential wealth engine. These include:
- Friction: The friction between real (inflation-adjusted) investor returns and nominal investment returns which consist of taxes, fees and inflation.
- Motivation / capacity: Not investing due to a lack of capacity or an unwillingness to save money combines with the lifecycle dilemma – the best time to invest is when you are young, but many young people lack the resources and foresight to invest early in life.
- Behavioural: Investing at the wrong time by buying assets when they are expensive and selling when they are cheap. In summary, people struggle to pay the price of volatility to gain the rewards of holding for the long-term.
I agree with the report’s conclusions that the market is an incredible engine to generate wealth. I also agree with the barriers to take advantage of it. But I think there is a hierarchy of reasons many people don’t achieve financial independence.
If building financial independence was easy everyone would do it. I’ve got some reminders of how to overcome these barriers.
Friction
Taxes, fees and inflation are not preventing anyone from building wealth. They are all unavoidable, but the goal is to minimise the impact so you can focus on motivation and behavioural impediments to financial independence.
How you do this is based on your personal circumstances and investment strategy. But there are some commonalities in how to view these sources of friction. They all relate to the foundation of the exponential wealth machine – compounding.
If you plan and circumstances allow flexibility focus on super prior to investing outside of super. Getting as much money into super early in life allows it to grow for longer in a lower tax environment. Later in life funds can be invested outside of super.
In all tax environments there is a benefit from delaying taxes. This is even more important given the changes to the capital gains taxes outside of super.
The capital gains discount increases the longer you hold onto an investment. If the overall returns are the same, shorter holding periods are always going to result in less wealth than longer holding periods.
Asset placement also matters. If your circumstances allow it hold assets with higher expected returns like shares in super while holding defensive assets like cash outside of super.
Fees also compound and even seemingly low fees make a big difference over time. An example is illustrative. AustralianSuper is the largest super fund in Australia and compared to other retail and industry funds the fees are reasonable.
But if you invest $10,000 a year for forty years in the MySuper option and pay a 0.53% annual transaction and management fee you pay a total of $389,928 in fees over the forty years. Fees add up.
There isn’t much guidance to provide about fees other than to ensure you are thoughtful about which fees you pay and the value they add to your investment outcomes
Inflation is another fact of life. Purchasing power falls over time which is exactly the reason you need to invest in growth assets in the first place. For perspective look at real – or inflation adjusted – returns. It will become apparent that investing too much in defensive assets like bonds and cash isn’t the pathway to financial independence.
Motivation / capacity
Capacity to save is undeniably an issue with all investors given the cost-of-living crisis. But I want to focus on motivation. The biggest advantage for any investor is time. This is something we give up too easily because we can’t stop focusing on the present.
In behavioural economics this is known as hyperbolic discounting. People put more emphasis on immediate rewards even when they are smaller than potential rewards in the future.
Data from US state lottery commissions show that between 90% and 95% of winners choose a lump sum payment over an annuity. The lump sum payment is generally discounted by 50% to 60% over the full value of the annuity. Yet people still choose the immediate reward.
I suspect that one reason instant gratification is so entrenched is a lack of financial literacy. Too many people don’t understand how small and consistent sacrifices today can turn into large sums of wealth in the future.
When I was younger and got my first financial calculator, I would constantly project out different savings and return scenarios. Seeing the potential wealth I could build under these hypothetical scenarios entrenched an early ethos of saving.
Even though I didn’t make much money and couldn’t save much I saw the impact I could make on my future. I had time on my side and that gave me a sense of control and motivation.
If you have better things to do than play around with a financial calculator– and please, find something better to do – I offer the following chart. It is based on the rule of 72 which is a trick to figure out how long it takes to double your money. For example, a 10% annual return would double in 7.2 years. Just divide 72 by the return.
The next chart shows the time to double your money with real returns which account for inflation.
Maybe you find this chart motivating and maybe you don’t. But the reality is that to build wealth means multiple doubles during your lifetime.
In an article on the rule of 72 I estimated that a comfortable retirement takes five to seven doubles in a lifetime. Get started as early as possible and get your savings into growth assets. The rewards may not be immediate, but when they come, they will be big.
Behavioural
I first started getting serious about investing twenty-five years ago. Back then I thought the formula for success was knowing more than everyone else. I worked hard to learn about investing and turned to the father of value investing.
I read the Intelligent Investor hoping to learn the secret to finding undervalued shares. In my zest to find the holy grail of investing I missed the most important lesson from the book which comes in the first chapter. Graham said, ‘the investor’s chief problem - and even his worst enemy - is likely to be himself.’
My thinking has evolved to align with Graham’s quote. Depending on how you invest it may be useful to know how to read a balance sheet or build a discounted cash flow model. Other approaches require less technical knowledge. But every successful investor must be able to minimise behavioural mistakes.
This isn’t another exhortation to focus on valuation. Buying low and selling high is an accurate but somewhat glib piece of advice. Assuring yourself you won’t panic in a bear market or get greedy in a bubble is easy to say and hard to do.
Success comes from having a goal and a plan and creating a framework that encourages good behaviour while dampening your tendency to fall back on your worst impulses. Not everybody can be Ben Graham. But all of us can control our own behaviour.
My new worldview is more empowering. I may not be an investing genius, but I have agency over my outcomes. Your own behaviour is the only thing stopping you from benefiting from the wealth-building power of markets.
Countless studies demonstrate the impact of poor behaviour. Foremost is Morningstar’s annual Mind the Gap study which shows investors miss out on 12% to 15% of the overall return of the underlying investments.
Final thoughts
The overarching lesson from this report is the power of compounding. Time plus strong returns is the formula for financial independence.
All the things holding investors back are also all lessons on compounding. The impact of fees and taxes accumulate over time. Procrastination and countercyclical investing derail the exponential potential of markets to build wealth.
Yet for all the good that compounding over the long-term can do there is an underappreciated aspect of this mathematical phenomenon. Most of the rewards come at the end.
If you invest $10,000 a year for forty years and earn a 7% return you will end up with $2.136 million. But close to 31% of the total wealth generated comes in the last five years of the forty-year period.
Building wealth is an exercise in foresight, patience and consistency. Most people struggle with all three. That is why most people won’t gain financial independence.
Questions, comments or restaurant recommendations? I can be reached at [email protected]
Additional reading:
Get your finances on track with Invest Your Way
Our book Invest Your Way is available in 206 bookstores across Australia. Kindle and audiobook versions can also be purchased.
Invest Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
Get Mark’s insights in your inbox
Read more of Mark’s articles
Read previous editions of Unconventional wisdom
What I’ve been eating
I don’t want to build financial independence so I can eat more omelettes. I want to do it so I can eat more omelettes in Thailand.
Researching the history of omelettes is exhausting. Are they Persian? French? Chinese? Apparently it was the Chinese that introduced omelettes to Thailand. Geographically that seems plausible, but chickens supposedly originated in southeast asia. I give up. Do you care? Because I don’t.
This Thai omelette is made with fish sauce, bean sprouts and crab. It is from Charmgang where I had a great meal in Bangkok’s Chinatown. I’m all for street food and a big Singha. But this was delicious and I’m not even a little bit embarrassed to say I had it with a bottle of Saumur.
