I’ve been reading and commenting on a lot of finance blogs lately, and as a group they’re beginning to piss me off. I’m not talking about the recycle your toilet paper folks. Those guys are unintentionally hilarious. And I don’t really care one way or the other about the debt bloggers. Good luck paying that off – seriously, I really do wish you the best. But I can’t help you with anything more than platitudes and common sense since I’ve never paid off a debt more interesting than a month worth of credit card purchases. And you can’t help me since I’ve got no debts to pay off.
No, the blogs that are pissing me off today are the ones giving well meaning but poorly though out investment advice. In particular I’m sick of the passive investor/ETF/dividend/DRIPs dudes and the people with two billion different letter combinations after their name that signal some sort of financial adviser or planner. It’s not really any one person or post or blog. I’m not going to make a list of the 10 shittiest investment posts of 2012 or anything like that. My issue is with the whole tone of the discussion. I’ll get to that in a little bit. But first I want to conduct a thought experiemnt:
What would happen if you invested the historical equivalent of $1 at the time of Christ, earning 2% real interest (ie. interest after inflation, currency changes etc.), and maintained that investment until the current day?
We can answer this question with a little math. The latest reasonable birth date for Jesus is 4BC – the year Herod the Great (the villain in Jesus’ birth story) died. We know Herod’s death date much more accurately than Jesus’ birth date because the Romans (for whom Herod was a client king) kept damn good records. So it’s been at least 2,016 years since that dollar (or Roman denarius) was invested. The easiest way to track investment results over long time periods is to apply the rule of 72. It says that an investment with a N% annual yield will double in value in 72 divided by N years. If you read the linked wiki article, you’ll see the rule isn’t 100% accurate. But it’s close enough for our purposes here. And it’s especially convenient since 2016 is evenly divisible by 72. That’s pretty handy, but it does put me on a time table. If I don’t finish this article in 2012 I won’t have another opportunity to avoid a bunch of awkward fractions until 2084. Luckily I should slip in before the deadline.
With a little division, we get that the number of doublings since 4BC is 28 times the interest rate in percent. So with a 2% rate you would have 56 doublings. That equates to slightly over 72 quadrillion dollars (or denarius). There’s that 72 again – a nice coincidence which wouldn’t have happened if I had waited until 2084 to finish the post. Lucked out again!
Now, 72 quadrillion dollars is is a lot of money. Since people have a hard time visualizing what a billion dollars is (let alone a trillion) you can be excused for having no clue how much a quadrillion is. I had to look it up myself. What I found is the total value of all property in the world (both public and private) is about one quadrillion dollars. In other words, this investment scheme would allow you to own the world 72 times over. Sweet! I’ve actually heard this argument used as demonstration of the power of compounding interest. If you thought something along those lines while reading, do yourself a favor. Find a good stiff book and smack yourself in the face. As far as I know there’s no clinical evidence that physical pain will cure brainwashing, but it can’t hurt. Or it will hurt but that’s sort of the point.
What do I mean by brainwashing? Well, if you do a thought experiment and the results come out absurd then you shouldn’t just accept it as some sort of pithy life lesson and move on. What you should do is triage your assumptions to find the mistaken one. That’s the whole reason you do thought experiments – to ferret out bad ideas. In this case we’ve got the following assumptions:
- That it was possible to invest the historic equivalent of $1.
- That investments can be maintained for an indefinite period of time.
- That it’s possible to earn a consistently positive real rate of return on investments.
Assumption 1 is clearly true. Investment has existed far longer than 2000 years. Assumption 2 is known to be true, because we have historical examples of such investment – notably the Roman Catholic church. They started a little later than 4BC, but more than made up for it with generous grants from various Roman emperors in the 300s AD. Now, since we have a real life example in hand, it’s interesting to ask what happened. And the answer of course is that the church’s investments paid off, but not nearly to the degree our thought experiment suggests. Rather than ending up owning everything, let alone everything multiple times over, they gained wealth but in a much more limited way – owning some tiny fraction of the world’s resources as of the present day. So if assumptions 1 and 2 are true, we need to carefully scrutinize assumption 3 to see why our thought experiment went wrong.
I find it useful to think about something I call the baseline rate of return. This is the rate at which technological and social improvement has enriched the individual. The average person today is much wealthier than the average person of antiquity. I’m not measuring this in money – I’m measuring it in terms of total goods and services consumed. How much wealthier is an interesting question (how do you compare a historical donkey to a modern SUV?) but I think we can put some meaningful bounds on the number. I would say modern people are at least 10x more wealthy than people from 4BC, but no more than 10,000x more wealthy. That’s a very wide estimate, but we’ll see in a second it doesn’t matter. From the estimate we can compute an upper bound the average rate of wealth growth for one person over the last 2016 years. If you use my high end number, personal wealth has grown by only 0.46% per year at most. That’s remarkably slow.
Now we can start to compare other rates of return to this baseline rate of return. If you’re returning more than the baseline rate at any given time, one of two things must be happening:
- either the returns are uneven, sometimes exceeding baseline rate (even by a lot) and sometimes coming in below it but with the average being baseline rate.
- or you’re grabbing a bigger piece of the total economic pie, expanding your wealth and thus control of goods/services compared to those around you. In other words you’re taking stuff from everyone else.
Now we can see what’s wrong with assumption 3 and why the thought experiment went wrong. The problem is that the 2% return is well above baseline rate. Since our thought experiment runs for such a long period of time, uneven returns can’t be the issue. The issue must be the resulting expansion of social control. The basic fact of the matter is that society won’t go along with unending 2% real gains. You can expand up to a certain point via greater than baseline returns, but past that point everyone else starts to fight back. They change the law to take your stuff. In extreme cases they shoot you (or in antiquity stab you) and take your stuff. But one way or another, your compounding growth comes to a halt, usually in one unexpected event. This is why the Catholic church or some other organization with a very long time horizon didn’t end up owning the whole world – the church was on their way when the Reformation put an end to their growth. Remember how Luther’s theses were about money first and foremost? The degree to which society takes these sorts of actions against an investor is directly proportional to the size of assets invested. Make a 2% real return on $1000 and no one gives a shit. Do it on say a twentieth of the world’s assets, and you’ll cause world wide disturbances in the economic system and massive blowback.
That brings me back to the blogs that piss me off and the topic of brainwashing. There seems to be a concerted effort afoot to convince blog readers that it’s possible to earn positive real returns well in excess of baseline rate by various fairly passive and unintelligent methods. The worst brainwashers are the financial adviser three letter brigade. They seem to always assume about 5% returns for retirement planning. In other words, 4.5% over baseline return. They used to assume 8% or even 10%, but people figured out that was bullshit. Now, let’s be clear: it’s completely possible excess returns will happen over whatever your personal investing time frame is. But if it does, it’s a historical oddity. This “returns will just happen automatically” mentality is the brainwashing I want to break you out of. Try replacing it with this new set of beliefs:
- Baseline real (post inflation) return on investments is slightly less than 0.5%
- The ability to exceed this rate can come from luck (in terms of when in history you’re investing) or from skill. If it comes from luck, you can expect reversion behavior – periods of excess returns are followed by lagging returns. We’ve just had excess returns for the last 100 years, at least in the US.
- If your returns come from investment selecting skill, then by definition you will have to be part of a small, active minority
- Large pools of capital can’t achieve excess returns by skill. The larger the pool, the more true this is. Society fights back and takes their excess wealth away one way or another. In other words, skill by definition involves doing something other people aren’t.
- Just doing something contrary to the herd isn’t enough. You must do something unpopular AND smart. There are plenty of unpopular, dumb options too and those must be avoided. This means you must be actively involved in order to distinguish between the two.
This goes a long ways towards explaining what’s happening to the US economy right now. People are complaining about 1.5% real GDP growth and asking if this is the new normal. You know what? It’s the old normal. Our population growth is about 1% per year, so 1.5% GDP growth equates almost exactly baseline growth rate in per capita GDP. This isn’t wierd. It itsn’t bad. It’s the way the world has always worked for the last two millennia.
Now let me suggest a radical step. The next time someone explains how their passive investment scheme (ETFs, DRIPS, target date mutual funds/asset allocation etc.) will earn you 5% real returns and carry you to retirement, tell them to sit down and shut the fuck up and stay away from your money. They’re almost certainly well meaning, but they’re weak students of history who don’t understand the way wealth really moves. If they turn out to be right, it will be only by luck. Personally, I plan to succeed by skill rather than luck so I want nothing to do with any of those things. I want my money to be part of a small pool of intelligently allocated capital doing things almost no one else is doing. That way, substantial real returns are possible.