cis(x)Pt 1 — Well Endowed
An intelligent way I think about managing personal wealth is based on few key principles — (1) generational thinking and (2) act like an endowment (with some caveats on portion sizes, (il)liquidity and leverage)
First things first
If you’ve got over $100M in your bank account, this is not for you. Go somewhere where people with over $100M in their bank account go :P
Alright, first we’re going to talk about generational thinking
What I mean by that is “most wealth is accumulated and built over generations”. Of course not always. You could be one of those business or scientific savants that goes on to build the next big Google, Apple, LVMH or Acme corp. But if you’re one of those individuals, you’re probably actually building the business right now rather than reading this rando medium blog.
Thomas Piketty presented it succinctly at his 2014 Ted talk, where he showed long term differences between 2 growth rates — return on capital and income growth. Specifically, he showed that return on capital exceeded income growth (it also resulted in significant variance in wealth distribution, leading to wealth inequality but that’s beyond the scope of this series).
To truly build wealth by leveraging the higher return on capital would then require us to operate (at the personal level) with the following guiding principles — control consumption to boost savings, make those savings actively grow for you by turning it into invested capital and gain from the power law effects of compounded growth.
Let’s look at a dummy example. You earn $130K a year that grows at 4% a year over 30 years (your average professional career). You save 20% a year and started out with some nest egg of ~$25K. Investing that capital averages you a return of 8% per year (the historical average of S&P 500 returns over 1957–2018). At the end of the period you’ve accumulated ~$4.6M. Now that’s a great thing in itself. But could we make it better?
If you’re trying to reach $100M or even a $1B, it’s more likely it will take you more than one generation. Most wealthy families get so over at least 2 generations. That’s where the generational thinking ensures you stay on track.
Some reading:
(1) https://academic.oup.com/sf/article/96/4/1411/4735110
Now about Endowment
Thinking like an endowment helps in 2 ways (one intuitive and one counter-intuitive) — (1) endowments function to smooth long term consumption that aligns well with the generational thinking model and (2) it makes the endowment effect bias work in your favor. (https://en.wikipedia.org/wiki/Endowment_effect)
So how does one think like an endowment? No you don’t need to precisely model your investment and finance decisions like the Yale Investment Office or the Harvard Management Company. Thought the poignant principles stand — study where your money is going carefully and cut down on non-essential spending/ consumption, balance your investments across liquid and illiquid investments.
While the liquid investments can be tapped into when you foresee higher consumption needs, illiquid investments allow you to benefit from their unique higher premia. The balanced approach makes better sense for individuals so that you still are liquid enough to not be shackled by having money but not a cent to spend.
A common argument against thinking like an endowment is their use of leverage. That a chief contributor to their higher returns is their generous use of leverage (by themselves or by managers who allocate on their behalf). That’s where time arbitrage comes in to offer a panacea to invidual investors.
See… large capital pools (as those managed by endowments) cannot make small allocations! It just doesn’t make sense to have 5,000 investments of $1M each. So they need to make large bets and restricts how agile those bets are. The size risk factor (https://en.wikipedia.org/wiki/Fama%E2%80%93French_three-factor_model) goes against them and leverage helps them expand upon their investment returns.
As a smaller investor you have the benefit of time on your side. You can enter and exit investments with much more ease. True leverage can still help you improve returns but it is not required to meet a certain hurdle rate and avoids the risk management concerns.
Well that’s it for this time. I’ll take a closer at investments, investment styles (active/ passive) and debt in the subsequent 3 articles.
Tschüss!
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