I am delighted to welcome a new occasional contributor to Monevator! Lars Kroijer was a successful hedge fund manager but he now advocates passive index investing as the best approach for most people. You can read more from Lars in his book, Investing Demystified
The vast majority of people have no edge over others in the stock market. Even professional fund managers who have demonstrated skill in picking stocks in the past struggle to beat the market once their high costs are taken into account.
This may sound like a counsel of despair, but it’s just a call to accept reality. You don’t need to beat the market to invest successfully in shares and other assets. But you do need to try to get the average return from the different asset classes as cheaply and effectively as possible.
I have a term for those wise people who have accepted this – I call them Rational Investors.
The way of the Rational Investor
In my book Investing Demystified
- As a Rational Investor you realise you can’t outperform the markets, neither do you know someone who can.
- The Rational Portfolio therefore consists of funds that track broad indices of equities as well as risky government and corporate bonds, and an allocation of “minimal risk bonds” 1.
- Think about your other assets in a portfolio context.
- Think hard about your risk levels.
- Be clever about tax.
- Implement the portfolio as cheaply as possible.
Keeping costs low is vital to being a Rational Investor. Since you are not going to try to outperform the market, it makes no sense to pay a penny more than you have to in order to achieve as close to the market’s return as you can.
Ironically, this will be your edge over those non-Rational Investors who are striving to do better.
By keeping costs low, you can end up richer than those who pay a high price to try to beat the market and fail.
Active management comes at a cost
There are too few people from the world of finance who are interested in emphasising the importance of low fees to investors.
Perhaps that’s not surprising – they are after all the ones making money from those same fees.
Fees are always important in finance, but even more so for the Rational Investor. Since we don’t think we’ll be able to outperform the market, we’re not asking anyone to be particularly clever about investing. We just want someone to replicate the market.
As a result we should expect to pay very little for it.
Inertia is a powerful force. It either makes us leave our investments where they are or makes us buy the well-known active funds like so many others.
Many people are aware of the extra costs of these active funds, but often they don’t seem to act on it. Instead, they accept the status quo – please don’t let that be you.
It seems paradoxical that people spend countless hours comparing the price of computers or holidays, when the same time spent researching better and cheaper financial products would far outweigh the cost savings they make elsewhere.
The price of active management
The following table compares the cost of investing in a passive index-tracking product with investing in a typical active fund tracking the same index.
| Active | Tracker | |||||
| Up-front fee | 2.00% 2 | 0.00% | ||||
| Annual | ||||||
| Management fee | 1.00% | 0.20% | ||||
| Other expenses 3 | 0.20% | 0.15% | ||||
| Trading costs: | ||||||
| Bid/offer | 0.35% | 0.25% 4 | ||||
| Commission | 0.15% | 0.10% 5 | ||||
| Price impact | 0.25% | 0.25% | ||||
| Transaction tax | 0.25% | 0.00% 6 | ||||
| Total per trade | 1.00% | 0.60% | ||||
| Turnover | 1.25x | 0.1x | ||||
| Total trading costs | 1.25% | 0.06% | ||||
| Additional taxes | 0.00% | (*) | 0.00% | |||
| —- | —- | |||||
| Annual cost | 2.45% 7 | 0.41% |
*Additional taxes may be payable with some even more active strategies.
Paying initial fees just to get into an active fund – the up-front fee of 2% in my table above – is becoming a thing of the past 8, but you can see from this example how you might still save another 2% a year by investing in an index tracking fund, compared to an active one.
If a 2% annual saving does not seem like a lot to you, then you’re forgetting the power of compounding returns.
Let’s assume that you’re a frugal investor who diligently puts aside 10% of their £50,000 income from the age of 25 to 67 (we’ll assume your income will go up with inflation, and to simplify our example we’ll also assume that this is an average over a lifetime – obviously few 25-year olds make £50,000!)
Let’s say you aggressively put all your savings into equities (this is just for illustration – in virtually all cases you should have a good portion of your savings in lower risk assets like government bonds).
How much of a difference would you expect your decision to invest in an index tracking product as opposed to an active fund to make?
For this example we’ll assume the following nominal cumulative returns before fees (and we’ll ignore taxes for now):
| Minimal risk rate | 0.5% |
| Equity risk premium | 4.5% |
| Annual inflation | 2.0% |
| —— | |
| Total | 7.0% |
So, we’re going to model for 7% returns from this investing plan. Where does this leave you in our example?
Well, as you get ready to retire at age 67 after 42 years of diligent index tracking, the difference in your savings pot is staggering compared to somebody who invested in active funds. All told you are better off by £643,000 by investing with an index fund as opposed to with an active manager.
Adjusting the £643,000 for inflation, that extra amount is still around £280,000 in today’s money.
- If you took the active route and managed to avoid paying the up-front charges, your active fund investment would have been higher by about £23,000 at age 67. That demonstrates the advantage of at least avoiding the initial charge.
- If you had avoided the up-front charge AND if there had only been a 1.5% annual difference in costs, then the difference in savings at retirement would still amount to £494,000.
If you think you have great edge in the market and you could easily make up this 1.5% to 2% annual cost difference by picking stocks or choosing superior active fund managers or timing the markets or whatever other approach you take, then good luck to you. All the odds and evidence are against you.
If you don’t have an edge, then the sooner you get out of the expensive investment approaches and into cheap index tracking products, the better off you will be.
(I’ll discuss exactly which index you should track in a later article).
Note: Shouldn’t I expect an active fund to make higher returns? In a word, no, you should not expect your active manager to outperform the index before fees. Obviously some managers will do so, but in aggregate the active managers together perform in line with the index before fees. It is because of their significant trading and management costs and other fees that active funds under-perform so starkly compared to index tracking products.
How to get an active manager’s sports car
By not giving money to an active manager (who probably was not able to outperform anyway) you saved £280,000 in today’s money in our example.
Just imagine the difference in quality of life that kind of money would make in retirement, or for your relatives after you are gone.
Conversely, consider the 85-90% of investors who invest in active managers as opposed to index tracking funds, either directly or via their pension funds. (Index tracking may be popular among Monevator readers, but it’s still a minority sport in the wider world!)
Over the long run only a very small percentage of investors who take the active approach will be lucky enough to invest with managers that give better returns after fees.
The rest have simply paid a staggering amount of money to the financial industry over their investment lives, and will have less money in retirement as a result.
To put things into perspective, the next time you see a finance person driving a Porsche or jetting off to a holiday home in Spain, consider that the additional and unnecessary active management fees paid by just one individual saver – added up over their investing lives – could buy seven to eight Porsches! And that paradoxically this is money paid to the finance industry by a saver who typically could not afford to drive a Porsche themselves.
If you know all this and are still happy paying high fees, then at least stop complaining about people in finance making too much money and driving fancy cars.
Note: What about picking your own stocks? You are not forced to choose between an active manager or index tracker. As many people do, you could manage your own portfolio with your own individual stock selections. This decision goes back to the question of having edge in the first place. If you don’t have edge – and the vast majority don’t – then this “do it yourself” approach is a loser’s game for you, as you will not be able to pick a superior portfolio to that of the market. Buying the market via index trackers will be far less hassle and much more cost effective. (If you do have edge, then I look forward to reading about you in the Financial Times.)
Passive investing requires patience
Focussing on fees when we seek investment success does not deliver instant gratification. As index investors there is no stock that doubles in a month. To really notice the additional profit we gain from being clever about expenses takes years or even decades.
The key to reaping the greatest savings is to have the patience for the compounding impact of the lower expenses to take effect. It is like making money while you sleep; lower fees make a little bit of money, all the time.
Consider the following chart that illustrates the aggregate savings from the two investing approaches we just examined.
In the early years you can barely see the difference between the active and index tracking investment approaches.
In the later years the benefits are obvious – but they are only there for the investor who kept his or her discipline with lower fees.
Ignore the siren songs of sexy managers
Once you understand the power of compound interest and how it adds up over several decades, then saving 2% or more a year in fees will sound like a much bigger deal.
But even then, you must remember it will take discipline to stick to this approach.
After all, 2% sounds a lot to you now when reading this article, but will you really notice the 2% you saved amid the noise of the investment markets?
In any given year – probably not.
The index tracker will perform slightly better over the long-term than the average active fund, and that outperformance will come from the cumulative advantage of lower fees.
Meanwhile the performance of the many active funds out there will be all over the map. Along the way the best performers will try to scream the loudest about how their special angle or edge has ensured their amazing returns that year.
We might even be tempted to believe these managers and abandon our boring and average index tracking strategy.
But please stick to your index investing plans unless you can clearly explain to yourself why you have edge.
The chances are you don’t, and you will be wealthier in the long run from acknowledging this.
Lars Kroijer’s Investing Demystified
- For UK investors, these would be UK government bonds, a.k.a. gilts.[↩]
- Do Not Pay This![↩]
- Audit, legal, custody, directors, etc[↩]
- Rebalance at times of liquidity[↩]
- Trackers don’t pay for research etc[↩]
- ETFs can typically avoid stamp duty etc[↩]
- Or 4.45% if you pay an up-front fee.[↩]
- Some active funds even have exit fees, but those are increasingly rare.[↩]
Good reads from around the Web.
Only a hedge fund manager could be arrogant enough to make a bet about investing returns with super investor Warren Buffett:
Results are in for the sixth year of the competition sometimes called the $1 million bet, and Warren Buffett — once a piteous straggler in this 10-year wager on stock market performance — has opened up a sizable lead over his opponent, New York asset manager Protégé Partners.
Buffett’s horse in the bet is a low-cost S&P index fund, and Protégé’s is the averaged returns to investors (after all fees) of five hedge funds of funds that the firm carefully picked for the contest.
The hedge fund partner who made the bet, Ted Seides, seems like a good sport, and by now he’s probably older, wiser, and ruing his foolishness.
Still, you have to wonder whether all publicity is good publicity, given the massive lead Buffett’s chosen tracker fund has opened up over its hedge fund rivals:
At the end of 2013, Vanguard’s Admiral shares — the S&P index fund that’s carrying Buffett’s colors — were up for the six years that began Jan. 1, 2008 by 43.8%.
For the same period, Protégé’s five funds of funds, on the average, gained only by an estimated 12.5%.
The index fund is beating the hedge funds by an extra 30% of return.
Oops!
I cannot tell you how many smart and sophisticated investors told me I was a simplistic fool for recommending tracker funds as the best vehicle for the investing majority six or seven years ago.
That doesn’t happen so much these days. Buffett’s bet is probably one reason.
Of course some hedgies will argue their funds reduce volatility, and that the price paid is lower returns.
But that only makes this bet a dumber one. It’s also not a good strategy for their clients, since as we often discuss here on Monevator, a good dollop of cash and government bonds will reduce volatility far more cheaply and consistently than an expensive hedge fund.
There may be times when the more exotic hedge fund strategies can deliver uncorrelated returns, which is indeed a useful thing.
But few people will ever invest to see it, and none of them are likely to be reading this website. (More likely a 1%-er who spreads his money across 10 invite-only small new hedge funds, and strikes it lucky with the 10th.)
In any event, I certainly wouldn’t bet on a bunch of hedge funds ever beating cheap index trackers over the long haul.
And I’d never bet against the master odds-juggler, Warren Buffett.
Move over Michael Lewis. His cautionary tale about Wall Street greed – Liar’s Poker
When gobsmacked readers discovered the vast riches being made by Lewis’ crazy cast of characters in the biggest money casino going, they flocked to New York and London to claim their share.
Lewis was horrified. But not so horrified that he hasn’t written a string of other excellent books about the so-called Masters of the Universe.
Check out The Accumulator’s review of The Big Short
A wolf in wolf’s clothing
It’s a good thing Lewis banked his royalties while he could, because now director Martin Scorsese has given stockbroking a sordid, glittering makeover that no novel could compete with for sheer flair.
The Wolf of Wall Street is a spectacular celebration of excess in all forms, with a tiny bit of morality tacked onto the end.
It’s almost – but very definitely “not quite” – a combination of Ferris Bueller Grows Up and Scorsese’s own Goodfellas – without the pasta!
It’s a love letter to greed that will send thousands of young cubs to The City and Manhattan in search of their own fast cars and mansions in the Hamptons.
Here’s the trailer:
Yes, I realise the Wolf, Jordan Belfort
But there’s a sliding scale from good to unethical to illegal, as the financial crisis so recently reminded us.
Besides, while a revolving door of prostitutes, midgets, and drug dealers is what made Jordan Belfort’s world go round, it’s always the money that grabs a certain kind of mind’s attention.
And money is back in abundance in finance today by the measures of all normal people, if not quite by Wall Street’s owned distorted measures.
Wolfing it down
The Wolf of Wall Street is a classic, but it’s not a truly great movie. Clips will be shown for the rest of our lives whenever there’s a financial scandal and some of the set pieces are spectacular, but it lacks the narrative arc of, say, The Godfather.
I’m not sure it’s any the weaker for it, though.
The message of the movie is that greed is more or less universal, and that out-of-kilter appetites cannot be satisfied by feeding them. Sticking a clever plot twist onto that might actually have undercut the film’s whole point.
I’d suggest you go and watch
But you should know The Wolf is not a traditional morality play.
Sure the (anti) hero comes unstuck at the end, but not before he’s had a three-hour blast. The film says these pump-and-dump masters were stupid to get caught. It doesn’t really say they deserved it.
And again, unlike some reviewers I think The Wolf of Wall Street is a better movie for it.
The reality is we live in a society that celebrates and rewards outrageous financial success with yet more success.
The schmucks who go to work for Leonardo DiCaprio’s penny stock peddling firm were crooks, but the film shows how the line separating them and the salesmen at the fancy blue chip firms can be more one of opportunity than ethics.
Who’s the sucker?
Scorsese’s truly masterly touch comes the final few seconds. It’s not a spoiler to reveal that the end of the film focuses on a room full of eager everyday people, desperate to learn how to sell dreams for profit from Belfort – who’s by that point a convicted felon.
The Wolf exists because too many of us are willing lambs to the slaughter. But we all have at least some of the Wolf as well as the Lamb in ourselves.
Yes, that goes for the excesses, too.
The Accumulator is a higher being than me and will probably find the hedonistic madness beyond the pale. I don’t mind admitting I could see some of the appeal.
I’d never live like it – heck, I saw the film mid-afternoon because it was a cheap ticket – but I can easily envisage why living like medieval princes at the height of their power in the capital of the intoxicating elixir of money can warp minds.
Sadly, I was saddled at birth with crippling disabilities when it comes to pumped-up hedonism, such as empathy, sentimentality, and a paranoia about my health.
Plus I don’t consider the chance to punch a co-worker in the face for access to a Bloomberg terminal to be a perk of the job.
Just say no
The Wolf of Wall Street is too long, the characters are only redeemed by the comedy, and the revelry eventually drags.
But even if the spectacle isn’t enough to make up for that for you, it should at least be an effective vaccination against ever – ever – giving any money to anybody who cold calls you on the phone
No exceptions – never do it!
Living in a capitalist society means questioning the other side of every financial transaction you ever make.
Take no-one on trust when it comes to your money.
Especially if you trust them.
Postscript
Curiously, when I got home from my trip to the Wolf’s fantasy land, I found I’d been emailed two article suggestions for our Weekend Reading links that covered the flip side of the excessive pursuit of profit.
I’ve already featured the one on mindless accumulation.
But it – together with this confession from a former hedge fund manager who admits he was furious at getting “just” a $3.6 million bonus in his final year – will be vital reading for any Monevator readers who go to see The Wolf of Wall Street and then afterwards find themselves clicking on the Goldman Sachs’ website.
At least you should know how far – or not – making money can get you.
Still, let’s not be too disingenuous. As one reader replied to the author:
I am sorry I took the time to read this article.
You quit after making several million, have set yourself up and now throw darts at the industry.
Give all the money away and start from scratch again and lets see how you feel.
And he’s right.
There will always be money making opportunities, and people who will bend the rules, and cycles that of booms and bust. It will never ever be regulated away, because you can’t legislate away need nor greed. It will always be with us.
That’s the ultimate takeaway from The Wolf of Wall Street.
p.s. Before anyone says the days of hedonism in The City are over – I say give it five years!
Good reads from around the Web.
There is a blue ceiling above London this morning. After 100 days of rain, it’s hard not to be sure that it’s the sky, as opposed to an incoming deluge.
I’m going to chance it and head Outside.
I admit it: I’m a capitalist. I believe in free markets. I think the invisible hand can do more than pick pockets and grope hard-pressed students packed onto the privatised railways.
Greed can be good – if it makes companies more efficient and brings more of us the products and services we want at lower prices.
Outrageous? Before you lynch me, you’d better know I’m not the only one.
We capitalists aren’t horned beasts dancing around pyres of sub-prime mortgage certificates. We’re men and women of all shapes, races, and ages. We have places where we get together, where we whisper to each other interesting business opportunities and swap tips on investing our SIPPs.
But these days we’re scared to be out and proud.
What a shame! We live in a capitalist world, and it’s only by living as capitalists that we can truly make the best of it. Capitalism isn’t just for golf club swingers and septuagenarians in South Kensington. It’s the system we all work within.
Unless you’re a dropout living in a tree tent above an anti-fracking campsite, you need to know the rules of the game to thrive. Taking a half-hearted approach to capitalism is like a goldfish taking a half-hearted approach to swimming.
You have to be in it to win it.
This is especially true as one of the least cuddly aspects of capitalism is it helps best those who help themselves.
The quickest way for the 1% to become the 0.1% is for the rest of us not to play the game.
With that in mind, here are 11 tips on how to be a capitalist.
1. Get some capital
Clues in the name. To be a capitalist you need capital. You can then invest this money to make more money, and be on your way to mega-riches. (Dust down your old Monopoly board if you’ve forgotten how it works).
I think one of the great strengths of capitalism is that it’s theoretically open to anyone. Rival systems claim to be more fair, but invariably they boil down to who you know (Marxism), who your parents were (feudalism), or who you were prepared to shoot in the head (dictator-ship-ism).
Most human beings will try to get ahead. Capitalism harnesses this, rather than fancifully suppressing it only to see it come out in less useful forms.
So, how do you get your capital?
Obviously it helps to be born to a rich capitalist 1. But most of us will need to spend less than we earn.
That difference is your seed corn. Saved and invested, it will be the start of your capitalist empire.
2. Own the means of production
Here’s what Karl Marx knew and you should, too:
“In capitalist countries, the rulers own the means of production and employ workers. Means of production are what it takes to produce goods.
Raw materials, machinery, ships, and factories are examples.
“Workers own nothing but their ability to sell their labor for a wage.”
If you want to thrive in a capitalist economy, you need to follow Uncle Karl’s advice and get yourself some factories, machinery and ships. Or rather their modern equivalents, like data centres, luxury retailers, and offshore oil drillers.
If you don’t own the means of production, then all you’re doing is selling your labour for a wage.
That is, you’re a wage slave.
Happily capitalism has come a long way since Marx’s time and it’s now easier than ever to get your share of the money-minting machines.
By putting your money into a stock market tracker fund, you’ll buy a slice of all the major listed companies in the country – or even the world, depending on which fund you buy.
These tracker funds are cheap to own, and enable you to leave your company managers to get on with making profits. As they do so, the companies will become more valuable, and the value of your holdings will rise.
By reinvesting the profits they pay out as dividends, you can buy more slices of the companies, too. Over time it’s reasonable to expect 5-8% growth a year in today’s money terms from your basket of global companies.
3. Own other assets, too
Owning a slice of the productive economy is key to getting your stake in the capitalist system, but companies are not the only assets to amass.
Other potential things to buy are rental properties, fixed income investments like bonds (where you’re basically making a loan to a company), and of course you want to keep some cash handy for future corporate raiding (a.k.a. buying into the stock market when it’s cheap).
You might even consider making loans to spendthrift wage slaves via Zopa, which now has a Safeguard in place that should protect you from bad debts.
The key is to have more income producing assets than money-sucking liabilities.
Some argue that our economy sneakily tries to turn even high-earners into indebted consumers. That way they stay on the treadmill of working and spending, enabling those at the top to stay rich.
I won’t get into the conspiracy theories here. But whether that theory is right or wrong, by refusing to play the consumption game and choosing to own assets instead, you’re closer to the top of the pile than the bottom.
4. Treat yourself as a company
Who is the archetypal capitalist – Bill Gates or Richard Branson?
For me Branson wins that matchup every time.
Gates may be richer, and with Microsoft he built a far bigger and more world-altering business than Branson ever did.
But Sir Richard is the consummate entrepreneur. He’s restless and forever shuffling his cards, always looking for how to best spend the next year and the next dollar to greatest effect.
Branson understood early the power of personal branding, especially in a nation of shrinking violets. And on a personal level, he doesn’t get hung up on what he can’t do (he’s dyslexic, for example) but rather on what he can.
Virgin is Branson, and his business activities are an extension of his ambition and of his curiosity about the world. It’s as far from the wage slave mentality as you can imagine.
Like Branson, you can treat yourself as a company, too.
What are your strengths? Where can you deploy your talents to earn the highest return? What assets are you not using, and where are you wasting money? Did you over-invest in a university education and under-invest in networking? Did you skip classes in the school of hard knocks?
What does your personal profit and loss statement and your balance sheet look like?
Not everyone needs to start a business or turn into an entrepreneur.
But to thrive in a capitalist world, it pays to sometimes think like one.
5. Turn yourself into a company
That said, it’s actually not a bad idea to become a company if you can.
I don’t mean you need to give up being a doctor or a programmer or whatever you are, in order to launch a rival to McDonalds.
But if you can you do your job as an independent, one-man band – a freelancer or consultant or small business owner – then there are plenty of advantages:
- You’re in control of your time and your productivity.
- With a diversity of clients (at least two!) you’re less exposed to the cost cutting measures of your capitalistic taskmasters. (i.e. Getting fired.)
- You’re usually taxed more attractively.
- It’s easier to put large amounts of money into a personal pension.
- No more idiotic office politics.
- If you invent something, you’ve a better chance of owning and exploiting it. 2
There are some disadvantages, of course.
When you run the show you can’t slack off, and the freelance and consultant budget can be the first to get chopped in hard times. Put money aside in case.
There’s also more paperwork, and you may need an accountant.
In many countries you’ll need to budget for healthcare, too, although in the UK we have the NHS to show for our taxes – a boon that’s often underestimated by UK entrepreneurs.
The next step beyond being a one-person show – running a proper, expanding business – is obviously gold stars and top marks when it comes to being a capitalist. Instead of making someone else rich, you have people making you rich.
Marx would say you’ve turned the tables. Now it’s you exploiting labour for your own profit – which is a result for our purposes.
Besides, there’s nothing to stop you implementing profit sharing or other enlightened benefits should you want to be a conscious capitalist.
It’s hard to start a business – much harder than some pundits with books to sell will tell you – and it’s risky.
I think becoming a self-employed problem solver is a good halfway house.
6. Create multiple income streams
Another baby step towards being the J. D. Rockefeller of your neighbourhood is to look for ways to add to your primary income.
Can you teach a musical instrument or a language, or some other skill? Could you invest in a franchise alongside an ambitious niece or nephew? Do you have expertise that would enable you to trade antiques for a profit? Could you write and publish your own digital books?
The list is very long, and your hours will be longer than Joe 9-5, too, so try to pick something you enjoy.
The benefits of adding extra income streams are you diversify your earnings, you can save and so invest more, and you think of yourself even less as someone with a job, and more as an entrepreneur. Mental beliefs are an important part of the picture here.
Don’t dismiss the value of even small amounts of extra income. Any additional passive income streams are valuable when you think of all the capital it would take to earn the same return in a low-interest rate world.
7. Diversify, diversify, diversify
Capitalists know the world is changing fast. Rather than moaning about it, they look for opportunities.
If you can address a strong need someone has, then they’ll pay you for it. Over time we get most of our new gadgets, services, and vices like this.
But that same rapid change that capitalism thrives on – and indeed fuels – is also a threat.
Sentimentalists think we should still be making all our own cars, washing machines, and aeroplanes in factories in each individual country.
Capitalists know global trade has (rightly) ended all that, but they also understand it could be their business that is “creatively destroyed” next.
Rather than hope that laws and regulations can protect your industry – let alone assuming you’ll have a job for life – it makes sense to diversify your skills, knowledge, investments, and other assets.
Be ready for total upheaval, because the chances are it will come at least once in your lifetime.
Getting the right balance is tricky, because capitalism rewards specialists – up to a point. They are more efficient, productive, and usually do a better job. But that also makes them expensive, which increases the chances they’ll one day be replaced by a robot, or cheaper talent in India.
I’ve personally tried to be a generalist for this reason. The alternative is to keep on the cutting-edge of your speciality, to stay young-minded, and to continually seek education and new opportunities.
Don’t fight inevitable change. Just ask the old music label bosses undone by digital file sharing, the engineers replaced by Japanese assembly lines, the IT managers whose jobs have been lost to The Cloud, and so on and on and on.
As for assets, old money diversifies, spreading its wealth. Many new rich people keep it all in one or two assets and either become a lot richer, or go bust.
8. Become an expert asset allocator
One huge reason capitalism works is because it harnesses millions of people’s individual decisions about where to put their capital and effort to best use, as well as what to spend it on.
In communist Russia, comrade Igor and factory chairman Alexander had to decide how many tractors the company would produce in five years. They’d consult with higher-ups in the party and local farmers, and be told there wasn’t enough steel anyway because some other comrade who ran the steel plant was pessimistic and had turned to drink.
These people were just as smart as us, but the system was stupid. They didn’t have the information required to best allocate their resources.
Capitalism replaces all this guesswork and centralised control with prices, which reflect supply and demand. Capital flows to the places where it has the best chance of multiplying, for a given level of risk. Prices of goods and assets change to reflect this.
The system is far from perfect. Despite what academics need to believe to make the sums work, none of us is ultra rationale. Amongst many other things, we get greedy, we get fearful, and we don’t always have perfect information.
As a result, capitalist economies have booms and busts.
Sometimes certain assets and opportunities are too expensive, while others are a steal. Capitalists can make mistakes at knowing which is which, just like two comrades could disagree on the national cabbage target for 1956.
Your job as a capitalist is to try to do a better job at telling the difference between cheap and expensive opportunities. You want your money – your capital – to be in attractive and sustainable places, and you want to pull some or all of it out of areas that look too frothy or, conversely, look doomed.
You don’t want to invest in flaky stocks at the height of the dotcom bubble, but equally you don’t want to retrain as a horseshoe fitter the year before Ford takes motor cars mass market.
Try to be alert to the relative attractions of cash, bonds, shares, overseas markets, and the other assets you invest in.
This is easier said then done, and many investors find they’re better off adopting a passive approach to their portfolio, periodically rebalancing to ensure they don’t become too exposed to fads. This method automatically puts money to work in the unloved – and under-priced – opportunities. 3
There are allocation decisions to make outside of your share portfolio, too.
Stuck in a country lane for two hours on a Friday night? Maybe it’s time to sell your holiday home. A third person asks if they can buy your antique Aston Martin? Perhaps you should sell it. Can’t sell your Spanish buy-to-let for love nor money, despite deep price cuts? Maybe you should be a buyer, not a seller.
You might not want to sell granddad’s medals from the war (I’m always amazed by how people on the Antiques Roadshow will swap precious heirlooms for two weeks somewhere sunny) but otherwise, all your assets should have a price where you’d sell.
And a price where you’d buy back in!
9. Be flexible
Be open-minded. Money doesn’t care where it’s put to work, and nor does a capitalist, beyond legal considerations and your own ethics.
How many people have daydreamed about opening a cool coffee shop? Countless – there are even books on it
Workers tend to pigeonhole themselves, whereas capitalists are business people first and foremost. Richard Branson is again the supreme example – he’s not just the record shop guy, the airplane guy, the fizzy drink guy, or the financial services guy – he’s all of that and more.
Stay alert to opportunities. They come up in strange places.
As a freelance I earn most of my money from something that began as a hobby when I was doing something else, and I have various other income streams that deliver the same again from assets I own.
I’m not Richard Branson. But I am a capitalist.
10. Minimise your taxes
Capitalists believe that free markets – and companies and consumers expressing their choices and voting with their wallets – deliver the most productive allocation of humanity’s resources.
That’s not to say markets necessarily deliver the “best” allocation, because the word “best” is so subjective.
I’d personally prefer half the money spent on cheap clothes in Primark went on conserving the world’s rainforests, for example, but few shoppers would agree.
What if 90% of people in the world got 100% richer but 10% got 50% poorer – would that be good or bad?
If you were one of the unlucky 10%, you’d probably think it was bad.
What if that 10% wasn’t at the bottom of the pile, but rather they were the richest? Is your answer different now?
This sort of conundrum – invariably combined with self-interest – is why even close friends rarely entirely agree about politics and economics.
I have dear friends who will find this whole post horrendous! The fact is though that I believe the private sector will deliver better outcomes in most cases. Even for some thorny issues. In my ideal world, beyond a safety net for all citizens, government is mainly about setting the rules for society to get the results the majority want.
Cleaner lakes and rivers? Less fat cats in the boardrooms? More houses? Fewer people dying of heart attacks? The State doesn’t need to make that happen through the public sector. Change the rules and set the right incentives, and smart entrepreneurs will find a way. 4
The logical conclusion is that a capitalist believes she knows better how to spend her money than the State does. Money is better off in our hands.
It’s a legal requirement to pay your share of the taxes, and I’m not suggesting otherwise. But there’s a big difference between tax evasion and tax avoidance.
A capitalist doesn’t donate money to the public purse – not when he or she believes it’s better being put to work by hungry entrepreneurs and companies. I don’t believe in a zero-sized public sector, but with the government already taking more than 40% of the UK’s GDP, I think it’s got enough to be getting on with.
Besides, if you’re taking the risks, why should the State take a big slug of the rewards?
Always take into account capital gains tax and taxes on income. Paying high taxes on your investments makes a big difference over the long term.
11. Give something back
My comments about taxes may have riled some readers, but I’m not praising personal gluttony and excessive hedonism.
I’ve not once mentioned driving sports cars, bathing in the milk of alpacas, or guzzling expensive champagne with high-class strippers (whether Wall Street asset strippers or the more traditional variety).
Although who wouldn’t want some that now and again? Perhaps not all the same time.
Whatever, it’s a personal choice that has nothing to do with capitalism. Many communist and socialist legends could spend money with the best of them on the backs of the workers. Plenty of capitalists have been wildly greedy, but Bill Gates has devoted the rest of his life and fortune to philanthropy, and Rockefeller didn’t drink or smoke.
Nobody succeeds in a vacuum. A healthy, educated population, family and friends, infrastructure, and the rule of law – none of this comes cheap. That’s why I’m happy to pay a fair share of taxes, and why I think it’s good to give something beyond that to causes that are meaningful to you.
Plus it feels good to spend your money helping others.
Some of the greatest modern mega-capitalists including Gates, Warren Buffett, and Mark Zuckerberg have pledged to give away at least 50% of their fortunes to philanthropy. Others work behind the scenes – and yes, a few inevitably want their names above the wing of a hospital or library.
Who or what would you like to help if you were wealthy?
Thinking about it might just help you get there.
- Because I believe in equal opportunity I’d support higher inheritance taxes, unlike my supposedly socialist friends who bemoan the taxes the State will claim when their parents in the Cotswolds conk out[↩]
- Check your contract. Many terms of employment stipulate your employer owns everything commercial you think up – even if it’s unrelated to your day job![↩]
- Passive investing is the ultimate way to trust in the wisdom of the market, making passive investors uber-capitalists, whether they like it or not![↩]
- Don’t blame capitalism that we don’t have a perfect and fair world. The fact is people don’t vote for a lot of things that would be better for everyone in the long run.[↩]
