Wednesday 14 February 2024

Why the first $1X is the hardest - further musings

Many people (including myself) had written (or done youtube videos) about why 'the first $100K is the hardest', and Charlie Munger famously said that investing your first one hundred thousand dollars is the most difficult part of creating wealth. It all boils down to the effect of compound interest, which according to Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”

But the effect of compound interest isn't restricted to the first $1 million -- it works exactly the same regardless of the order of magnitude (multiples of $10 million, multiples of $100 million, multiples of $1 billions etc.)

I did a quick excel illustration of this, using a fairly typical savings/investment rate of $10,000 pa and an after tax investment return of 7%pa. Of course achieving a 7% return is easier said than done -- using a tax efficient vehicle (eg. superannuation or 401K) is important for 90% of the population aspiring to their first $1 million, and explains why 'the rich' tend to relocate to a 'tax haven'. And to have any hope of getting 7% real returns you would have to be risk tolerant and accept considerable volatility (eg. invest in equities rather than bonds or cash).

The results show that while earnings and savings rate are important while you are accumulating multiples of $100K (or even more so if aiming for multiples of $1K or $10K), income becomes largely irrelevant once you are past your first $1 million (hence the real reason why 'the rich get richer' without seeming to have to do any personal exertion -- unless you are at the very top of a lucrative career (eg. movie star, sports no.1 or similar) once you have a few million invested, your personal income is irrelevant).

The number of years to move from your third million to fourth million is practically the same number of years needed to move from your third $100 million to fourth $100 million, or from your third billion to fourth billion...

It also shows why nearly everyone is on a lifelong struggle to aspire to become a 'millionaire' -- as we are nearly all starting from $0 at age 20ish, and can aim to save and invest 10%-30% of somewhere around average income during our working lives (of 40 or so years). And why anyone born with a 'silver spoon' (eg. a $1M trust fund or seed capital provided by a wealthy family) will either blow the lot or be a financial success even if they do nothing but leave their investment sitting in an index fund and earn enough to pay the bills.

Unfortunately most people either just earn enough to 'get by' (often relying on welfare to make ends meet) and don't save anything at all, and a large percentage of those that do earn more than average income just increase their spending ('lifestyle creep') rather than boost their savings and investment rate. This is why despite the 'magic' of compound interest, the median net worth of households in most countries has 'flat lined' over many decades, rather than increasing exponentially.

It doesn't bode well for 'closing the gap' between the 'top 1%' (or 10%, or 25%) and the 'average' person. Compulsion (such as the Australian Superannuation Guarantee Levy) is about the only way to 'force' most people to accumulate wealth during their working lives -- and most people prefer to have the 'choice' to spend their earnings as they see fit -- even if it results in perpetual financial struggle for most people.

Mathematics is a cruel mistress.

ps. One thing I do find odd is that the exponential growth of wealth seems to break down once you get to billionaire status --rather than continuing to grow exponentially, it seems to transition to a linear growth rate beyond a certain point. I can't imagine that lifestyle/expenses can continue to rise exponentially, so it seems more likely that beyond a certain point it gets more difficult to find suitable investment options (or perhaps the mega-rich just become ultra-conservative and invest mostly in cash and bonds once they have a billion or more?).

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1 comment:

mOOm said...

I think the linear growth is mainly an illusion due to the time periods. Compare the rate of growth during the 1990s bull market compared to the rate of growth of total net worth in the post 2009 bull market. It's much more rapid in the latter. Where are these data from? The shrinkage in number of billionaires from 1996 to 1998 looks suspicious. Most billionaire wealth is probably in business equity whether listed or not... One factor reducing growth is giving money away to charity...