Notes to my son: On wealth
This is going to be a long read, but I can safely promise the time invested will earn a good return.
In the winter semester of 2004, on January 26th, 2005, I walked up to the Bronfman building, treading through slippery and slushy sidewalks to attend an introductory finance class at McGill University. Professor Liu was animated, as always, but I found finance rather dull and settled down to take notes for the semester exam. Little did I know the seed he planted that day would give shape and meaning to my life.
He spoke of compounding. To provide a zero jargon summary, simple interest is addition, and compound interest is multiplication. Multiplication is faster and results in more growth.
This difference is valuable even in short horizons of a year or two. But look happens over longer periods. Prof Liu explained: “Imagine you start with $10,000, invested at 5% per annum. Over 10 years, that sum becomes $16K. Over 20 years, it becomes $26K. But at 40 years, it becomes $70K. That is seven times what you started with.”
For the first time, I raised my hand in a finance class. “What if you increase the period to 80 years?” He replied, “It would be a greater, even an astronomical increase (my insertion: the answer is an astonishing $495,000!). But who lives that long?”
Now, years later, I know the question to ask is not who, but what. ‘What lives that long?’ is a more powerful question. And the answer is family. An individual cannot realistically hope to benefit from more years of compounding than life expectancy permits. But the family unit can.
There are three elements in the compounding equation: the sum you start with, the rate at which it grows and the time for which it compounds. The starting sum is necessarily small; if the sum is already large enough, you would not need this equation. The rate of return is what most people focus on. Professor Liu showed us that moving from 5% to 10% returns produced tremendously better results. But, he cautioned, you have to be really good to consistently produce 10% returns over 40 years. Most people cannot.
If most people cannot produce high returns on their investments, then what is the use of most people trying to do so?* It is more reasonable for them to accept an average rate of return.
By contrast, if you double time rather than returns, growth is equally powerful. Starting with $10,000 and compounding at 10% for 40 years yields $452,000. Whereas compounding at 5% for 80 years yields $495,000. Growth that leverages time is more certain and easy than growth that leverages skill for higher returns. The passage of time is inevitable; the distribution of skill is a matter of chance as much as individual choice and effort. To use an analogy, would you prefer to sail with the wind, or row against the current all day?
Prof Liu was operating in the paradigm of individualism, where every generation of individuals is trying to get the best of the compounding equation in isolation. He was right to assume that most 20 year olds would probably retire around the age of 60 to 65. Even if they were highly disciplined and started investing with their first job, their compounding span is 40 years. That’s why his graphs stopped with that time horizon.
I went home and tried out more horizons. I have stated the sum of $10,000 grows to $495,000 after 80 years. At 120 years, the total wealth is $3.4 million.** Since individuals cannot in the present day increase the time allotted to them beyond a limit, the family thus emerges as the natural unit of wealth-building.
These periods of time may seem fantastical. But we are talking about a period that spans my grandfather’s first salary to my age of retirement. That is achievable and that is what I will do for your children.
What if my mother’s great-grandfather had done this? Had he set aside (Indian rupees) Rs. 100 for my mother when he was 20 years old, by the time my mother was married, that would have matured to Rs. 200,000. It sounds small today, but at the time was enough to buy a flat. What matters most is not the sum you start with, which can be small; or the skill you invest with, which can be average; but the time you stay invested for.
Of course, there were other limitations at the time. Investments that compounded steadily over time with low risk were not plentiful. Most people did not (and still do not) have the financial know-how to invest at low fees and taxes. People also had more children then, and women did not inherit. While my mother grew up in a relatively well-off extended family, her own family’s existence was hand to mouth.
Today, all it takes to benefit from compounding is a family with vision, strategy and discipline. What I desire for our family is that the baseline vision and strategy are formed and institutionalized into habits and mindsets in your generation before I pass on. But if that does not come to pass, you must make it happen. Once that foundation is laid, any person of average intelligence, with an average work ethic, will be able to tweak the framework for the circumstances of the future.
If you can devote yourself to this task and inspire your children to do so, the family will benefit from extended periods of compounding at reasonable returns with acceptable leakages to taxes and fees. The pace of compounding will exceed the division of assets at death between siblings, and the family will grow wealthier slowly but surely, over generations. This is your duty, and this is the only expectation I will impose: think beyond your individual lifespan, and live with vision.***
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* One of the most consistent truths of our world is that people despise the average, though they constitute it. Everybody wants to be ‘above average’ though this is mathematically impossible. If they all succeed, they will find themselves average again, because the average level rises with collective efforts. Wonder at this for a moment: though motivated by the desire to be relatively better off than others, each individual’s effort only collectively makes the group better and nobody is as relatively better off at the end as they intended. This doomed pursuit of higher status and accomplishment drives the rat race and the engine of capitalism forward, and was termed the ‘invisible hand’ by Adam Smith. A discussion for another day, once you are old enough to talk.
A strategy that succeeds relies on the average. Producing above-average returns requires above-average skill and luck. Why rely on skill and luck, which are scarce, when one can rely on time, which is unlimited?
Let those who are skilled — which is of course determined by a combination of genetics, inclination, experience, effort and environment — strive for higher returns. Everyone else would do wisely to accept average returns (which finance folks call market or benchmark index returns).
**If you are discerning, you will expect to know the impact of inflation. Conservatively assuming a 5% return is accompanied by 2% inflation, $10,000 grows to inflation-adjusted, present-day amounts of $31,000 in 40 years; $101,000 in 80 years and $324,000 in 120 years. The gains are still significant.
***Once you realize the possibilities of this way of thinking, your life changes. Where earlier, skill, intelligence and luck may seem important to earn great wealth, we realize that wealth is equally a matter of vision, discipline and family stability & unity. And where previously one may casually scorn stability and take risks, now we will do so with greater awareness of what it might mean for future generations.
