Why Invest Forever? (Part 7)

Key Points

  • The rich continue to get richer, where the top 26 richest humans now control more wealth than the bottom 50%, based upon recent research from Oxfam.
  • Wealth has the capacity to grow exponentially after reaching a tipping-point, which can lead to a strong concentration of wealth among a small percentage of owners.
  • If you can’t beat ’em, join ’em.

26 People

Twenty six humans—less than half the amount of students that can fit on a school bus. Also, less than half the amount of players on the roster for an American football team. Twenty six people—according to Oxfam, this is how many humans it takes to control the same amount of wealth as the poorest 50% of the global population, which represents over 3.8 billion people. That’s 26 versus 3,800,000,000+ people.

In the last post of this series, I showed how $1000 can grow to over a $1 billion (before taxes and fees) by just compounding at a real (inflation-adjusted) rate of return of 7.2% a year for 200 years. We’ll attack some of the main assumptions that underlie this analysis soon enough. But the key point of all this is that with enough time and a sufficient return on investment, exponential growth in wealth can be obtained.

Seeking Rent

If you ever heard the saying, “the rich get richer, and the poor get poorer”, some of the analysis presented thus far may provide insight as to why this may be the case. Indeed, the underlying basis for this phenomenon is quite simple to understand. For the non-wealthy, investments are few and far between, and further almost all income generated from investments (i.e., capital gains, dividends, and interest) is not reinvested but rather spent to cover living expenses.

However, for the wealthy, investments make up the vast majority of net worth, and almost all income can be reinvested given that the income generated greatly exceeds any reasonable level of living expenses. Accordingly, there’s a tipping point in wealth creation that once an investment reaches a certain level beyond what is required for spending, the investment can simply continue to accumulate and can even grow exponentially with little effort (i.e., through a passive investment strategy).

There’s a notion in economics that’s somewhat related to all this, so let’s explore a bit further. It’s known as rent-seeking, and it was a principle first put forward by Adam Smith. Smith’s seminal work was foundational to the field of economics. As such, we’ll be sure to dig into his philosophy and theories in greater detail later on given his significant contributions to the fields of economics, finance, and investing.

Adam Smith was an 18th-century philosopher renowned as the father of modern economics, and a major proponent of laissez-faire economic policies.—Investopedia

Based upon the work of Smith, income can be obtained from three primary sources: profit, wages and rent. Profit requires putting capital at risk, in hopes of generating a return. Wages aims to convert labor into income. And then there’s rent.

Rent is the easiest and least risky type of income because it requires only resource ownership and the ability to use those resources to generate income by lending their use to others.—Investopedia

Since there is less risk with this type of income, it’s in any investor’s best interest to seek out rent whenever possible. However, rent-seeking can have its drawbacks on society. Essentially, an “inventor” can seek rent and earn an income but never add any economic value, which is good for those collecting the rent, but not so great for those paying the rent.

A classic example of this concern is as follows: let’s say there’s only one road that connects two cities and our investor happens to come into possession of a small stretch of that road, let’s say a one-millimeter stretch that happens to fall halfway between both cities. Now let’s say our investor begins to charge a $10 toll for any car wishing to use this small stretch of pavement.

The investor might argue that the cost of the toll is meant to pay wages for upkeep of the small stretch of road and also to earn a profit on the original cost to obtain the segment. But in reality, the toll is basically rent, where the investor is collecting money just because he or she happens to be the owner of the property. No economic value is created by owning this investment; it’s essentially rent-seeking.

According to Oxfam, “Our economy is broken, with hundreds of millions of people living in extreme poverty while huge rewards go to those at the very top.” The notion is simple: from the beginning of civilization until now, the borrowers have always been slaves to the lenders; the tenants have always been slaves to the landlords. Essentially, those at the very top collect rent, and essentially everyone else pays it.

The wealth of the world’s billionaires increased by $900bn in the last year alone, or $2.5bn a day. Meanwhile the wealth of the poorest half of humanity, 3.8 billion people, fell by 11%.Oxfam

Money flows away from the wage earners to the asset owners. And the only (legal) way to charge rent is to become an owner. This is how society works after all.

You Can (and Likely Should) Do It Too

So how does this impact you? A common criticism of capitalist society is that without effective controls, income gets pulled away from profit and wages and ultimately gets funneled into rent. If the means of production are controlled by a few individuals, the few can collect more and more rent, by buying up more and more means of production. It’s a viscous (or virtuous), cycle (depending on your perspective).

In economics and sociology, the means of production (also called capital goods)[1] are physical and non-financial inputs used in the production of economic value.—Wikipedia

Given all this, the lesson society teaches us is clear and simple: it’s far better to collect rent than to pay it. When we talk about rent in this case, it’s not just the money collected from owning property, it’s also the money collected from owning any asset or commodity or thing of value.

For example, if you controlled the entire fresh water supply on a remote island, you could charge $100 a bottle even though it costs you pennies to produce. You can then use half of your proceeds to fund your Super PAC aimed at burying any political opposition. Simple enough, right?

Other examples of rent-seeking opportunities include prescription drugs, gas right next rental car agencies, movie theater popcorn, airport beverages (after you pass security, of course). Businesses can sell these goods can at prices that are far higher than what’s warranted given that they operate in situations where the rights to a resource or commodity is scare and controlled by a rent seeking entity.

Accordingly, when you purchase a stock of a company you obtain ownership of a percentage of that company’s means of production. The same goes if you invest passively in an index fund such as one that invests in the 500 companies that makes up the S&P 500 Index. And if you follow this strategy long enough, you too can create exponential wealth by owning more and more means of production.

Now you won’t be collecting a wage from this particular endeavor, but you will be putting your capital at risk so you can hope to turn a profit. Nevertheless, you will also be owning means of production, and thus part of the income generated from your investment inevitably will come from rent. The more your investment grows, the more you can collect in rent. And as we’ve seen, with enough time, a small investment can grow to a great fortune if income is allowed to be reinvested rather than consumed.

This may not be the best way to govern a society, but as this analysis from Oxfam makes clear, this phenomenon isn’t going to change any time soon.

“The number of billionaires has doubled since the financial crisis and their fortunes grow by $2.5bn a day, yet the super-rich and corporations are paying lower rates of tax than they have in decades.”—Oxfam

There are compelling structural reasons why this imbalance of wealth creation exists, taxes being a vital component. Nevertheless, this is something that we’ll have to cover at a later time as this particular topic requires plenty of analysis on its own.

Indeed, the rich do have capital at risk, so one might conclude that any wealth that’s created is simply profit. However, if wealth just increases for the rich, then is the income profit or is it really just rent? I surmise that since the rich don’t necessarily need access to most of their wealth in order to live and survive, the rich have the seemingly unique luxury of Investing Forever.

Therefore, with such a long timeline to play with, the chances of losing money can be quite low for astute wealthy individuals. As we have seen, over any 45-year period since 1871, the S&P 500 Index has posted a positive return. From this perspective, the phenomenon of rent-seeking may go a long way in explaining the outcomes we are experiencing lately, where the rich end up accumulating more and more wealth over time.

But for added color on this, see Figure 1 below. The pattern is pretty clear; over time, the top 1% of wealthy individuals are controlling more and more of the total amount of wealth within the United States.

wealth_inequality_panel_-_v1
Figure 1. Over time, the control of wealth within the U.S. has become more and more concentrated at the top.

In 1979 the top 1% of wealthy Americans controlled less than 25% of the nation’s wealth. But by 2012, the top 1% ended up controlling over 40%. Accordingly, my candid advice is simple: all else being equal, be an owner not a renter. And a great way to do this is to simply invest forever. But of course, the devil is in the details, so let’s see just how easy (or difficult) this endeavor can be in Part 8 of this series.