Wednesday, July 6, 2011

How Instant Wealth is Created

To understand how this is done, it is necessary to think in terms of two different capital markets. The first capital market is the market for physical investment. In this market, firms and individuals make real investments in plants and equipment. The second capital market is the financial market where individuals buy financial instruments (ownership rights) without directly managing real plant and equipment. Stocks, bonds, and real estate trusts are examples of the latter; factories, stamping presses, and lathes are examples of the former.

Instant wealth arises in the process of capitalization. Consider a real investment in plant and equipment of $10 million that earns $3 million per year. Suppose that the market rate of interest or the discount rate is 10 percent. With a 10 percent discount rate, a $3 million annual income flow is worth $30 million ($3 million/.10) in the financial market. If the discount rate were 5 percent, the same investment would be worth $60 million. This is true regardless of how much it cost to make the initial investment. But in the example, the initial investor has now increased his wealth instantly from the initial $10 million to $30 million when the investment was sold. The purchaser who buys the stock for $30 million, however, has an investment that only earns the market rate of interest (10 percent). If the real investment opportunity were something that could be duplicated by the initial investor, his $10 million investment might be worth even more because of the future profits that similar investment could bring.

It is this process of capitalizing above-average returns that generates rapid fortunes. Patient savings and reinvestment have little or nothing to do with such fortunes. To become very rich one must generate or select a situation where an above-average rate of return is about to be capitalized.

If real capital markets reached equilibrium quickly, large fortunes could not be made in this process of capitalization. Once a new physical investment opportunity was discovered, real investment funds would quickly flow into the area and bring the real rates of return down to the market's average rate of return. Above-average profits would not be expected to last very long, and there would be no possibility of obtaining a monopoly on future above-average physical investment opportunities. Other people would move into the area and future physical investments would only earn the market rate of return. In this case, physical investments are only worth what they cost to build and cannot cause sudden additions to wealth.

Data on real capital markets indicate little if any tendency for the real capital markets to approach equilibrium. Substantial, persistent differences in real rates of return exist. The reasons for this fundamental disequilibrium are many and varied, but most of them spring from a basic characteristic of real investment markets. Investment resources simply do not flow quickly across firms and industries thereby equalizing real rates of return.

While the process of capitalizing disequilibrium rates of return explains instantaneous wealth, there is still the problem of how these fortunes are allocated to individuals. This brings us to what is called the random walk. Since no one can predict where these opportunities for capitalizing real disequilibrium out of existence will appear, the winners are, as in any lottery, lucky rather than smart or meritocratic.

The random walk is a process that will generate a highly skewed distribution of wealth. You cannot lose more than you have, but you can make many times what you have. Because most holders of wealth eventually diversify their portfolios, great fortunes remain even if the underlying disequilibrium in the real capital market eventually disappears. It should be emphasized that there is no equalizing principle in the random walk. Those who have had good luck are no more apt than the random individual to be subject to bad luck.

What is evidence for the random walk hypothesis? First, an examination of large financial firms (such as mutual funds) indicates that none of them is able to outperform the market averages over the long term. Professional financial managers able to make large investments in obtaining market information are not able to outperform the market average or a random drawing of stocks. Second, no one has been able to design a set of decision rules (when to buy and sell) that yields a greater than average rate of return. Third, tests indicate that stock prices quickly adjust to changes in information (announcement of stock splits, dividend increases, and so forth). Fourth, there is no serial correlation among stock prices over time. The price at any moment in time or its history cannot be used to predict future prices. When put together, all of these findings form an impressive body of evidence as to the existence of the random walk.

While many of the great fortunes represent a combination of entrepreneurial and financial investments, the same random walk process probably holds. Ability is necessary, but within a group of individuals with equal entrepreneurial talents a nonnormal random lottery occurs. There is an expected rate of return for the group as a whole, but there exists a wide dispersion in individual results around this average. Entrepreneurial talent is a necessary condition for entering the lottery, but it is not a sufficient condition for making instantaneous wealth. The entrepreneurial random walk is, however, much less subject to proof than the purely financial variant. The unsuccessful entrepreneur does not remain visible for study in the same manner as the unsuccessful stockholder.

The net result is a process that generates a highly skewed distribution of wealth. Great wealth is created in relatively short periods of time. Personal savings behaviour and one's ability to postpone future gratification have little or nothing to do with the process. Once created, large fortunes maintain themselves either because the underlying disequilibrium in real returns remains or because investments are diversified and earn the market rate of return.

If you read the Fortune biographies that accompany their lists of the most wealthy, the winners will be described as brighter than bright, smarter than smart, quicker than quick. But look beyond the description to see if they were simply lucky or possess some unique abilities. Remember that the unsuccessful entrepreneur of equal ability will not be featured in Fortune. To what extent were they like many other people but in the right place at the right time? The real test of unique abilities is to ask how many have repeated their performance. How many have made a great fortune on one activity or investment and then managed to go on to earn another great fortune on another activity or investment? If the Fortune list is examined, it is impossible to identify anyone whose personal fortune was subject to two or more upward leaps. The typical pattern is for a man to make a great fortune and then settle down and earn the market rate of return on his existing portfolio.

What has been generated in this process is realized and unrealized gains. Realized capital gains are taxed at less than half of normal rates, and unrealized capital gains are not taxed at all. Those multibillionaires in the Fortune undoubtedly paid little or no taxes. Nor should one imagine that it is impossible to consume unrealized capital gains without paying taxes. Simply go to your friendly banker (if one is a multibillionaire, there are many friendly bankers), take out a loan using your appreciated stock as collateral, and buy whatever you like. The interest payments on the loan are even tax deductible. You can consume whatever you like and pay no taxes. At death, the principal can be repaid out of that same appreciated stock.

1 comment:

  1. You've explained it well. I used to follow wealth management blog from a financial adviser, Ed Butowsky. This one is also great :)

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