Showing posts with label Understanding wealth. Show all posts
Showing posts with label Understanding wealth. Show all posts

Tuesday 14 August 2012

"Whatever you have, spend less." If compound interest isn't working for you, it's working against you.

By keeping what he has, and adding to it by living below his means, the Master Investor lets his money compound indefinitely.  And compound interest plus time is the foundation of every great fortune.  

Wealth is really a state of mind.  In the words of Charlie Munger:  "I had a considerable passion to get rich.  Not because I wanted Ferraris  -- I wanted the independence.  I desperately wanted it."  If you share this attitude, once you have gained that hard-fought independence the last thing you're going to do is jeopardize it by blowing all your money.

The alternative to living below your means is the debt-laden pattern of the middle class:  If compound interest isn't working for you, it's working against you, bleeding your money away just as a spurting artery drains your life-energy.




Additional notes:

Most people want to be rich so they can fly first class, live it up in the Ritz, feast on champagne and caviar, and go shopping at Tiffany's without giving a second though to their credit card bill.

The problem is that people who have this attitude to money don't wait until they're rich before they start indulging their fantasies, even if only on a small scale.  As a result they never accumulate any capital, or even worse go into debt so they can live beyond their means ... and remain poor or middle class.

"Understanding" versus "Knowledge"

You can put knowledge in a book and sell it.  But not understanding.

To understand is to combine knowledge with experience.  Not someone else's experience: your own.  Experience only comes from doing, not from reading about what someone else did (though that can add to your knowledge).

The meanings of these two statements are clearly different.

Mr. A has a good knowledge of investing.
Mr. A understands investing.


Knowledge usually means a collection of facts - a "persons's range of information," or the "sum of what is known."  But "understanding" implies Mastery - the ability to apply information and get the desired results.

Thursday 27 May 2010

Who Creates the Wealth in Society? (Part 3 of 3)

MAY 21, 2010, 6:00 AM
Who Creates the Wealth in Society?

By UWE E. REINHARDT
Uwe E. Reinhardt is an economics professor at Princeton.

This is the third post in my trilogy on the creation of a nation’s wealth.

In the first I explored what is meant by wealth. The second looked at companies as creators of wealth, with a digression on the social and economic purpose of business corporations. In this concluding post in the trilogy, I explore who are society’s main creators of wealth.

In so doing, I shall draw heavily on a lecture entitled “What Is the Wealth of a Nation?” that I delivered in 2002, at the end of a freshman economics course. Earlier posts in the trilogy drew on that lecture as well.

The lecture was inspired by the cover of a well-known business magazine that celebrated “America’s Great Wealth Creators,” with photos of dot-com heroes of the day and Jack Welch, the chief executive of General Electric until 2001. The magazine was celebrating, of course, the market capitalization of the companies led by these “wealth creators.”

This occurred toward the end of what we now call the dot.com bubble, as the price-to-earnings ratio — the market price of stocks relative to earnings — soared far above historical values, while silly books like “Dow 36,000: The New Strategy for Profiting from the Coming Rise in Stock” by James K. Glassman and Kevin A. Hassett were greeted with the utmost respect on Wall Street and in the media.

As it turned out, much of the what these “wealth creators” were said to have created was ephemeral (see the graph below and also my post “Jack Welch and the Lone Ranger Theory“), just as the subsequent fabulous wealth created by the financial sector during 2004-8 has been ephemeral.

The point of my lecture was not that businesses and their leaders do not contribute to creating the nation’s wealth. Far from it (see my paper “On the Not So Simple Steps Involved in Starting a Business Venture“). By organizing and focusing a variety of resources in a way that produces products and services designed to please someone, businesses make a significant contribution to the creation of value and wealth.


Yahoo General Electric stock performance over time, compared with major indexes. Black triangles indicate stock splits.

My point in the lecture was merely that the precise magnitude of the contribution a company makes to wealth is not easily measured, and certainly not by its market capitalization. Furthermore, I pointed out, the value and wealth contributed by companies and their leaders come only at the end of a long chain of wealth creation on which businesses capitalize, starting with the basic unit in society: the family.

It is now well recognized that the wealth of modern societies is dictated not so much by the natural resources at their disposal, but by their human capital the knowledge and skill of human beings and their ability to learn and apply new knowledge on their own.

Anyone who has raised children to maturity appreciates the magnificent contribution conscientious parents can make to this human-capital formation, because much of the education of youngsters takes place in the home. Conscientious parents — and especially mothers — rank as the major wealth creators in modern societies, as, of course, do the offspring whose own effort is crucial in assembling that capital.

Next come educators, especially the visionary and dedicated elementary and high school teachers who succeed in getting their students interested in learning and motivated to amass human capital. The role of such teachers in the wealth-creation process is not sufficiently appreciated in our latitudes.

We at the level of higher education also contribute, of course, to the process of human-capital formation, but we have the privilege of preselecting our students and probably deserve less credit in the wealth-creation chain than do parents and high school teachers.

None of the forgoing is to say that being highly educated and skilled is either a necessary or a sufficient condition for contributing value and wealth to society. Anyone who works, be it for pay or as a volunteer, does so.

Finally, what about government? A common mantra in the United States is that “government does not create wealth, people do.” We shall hear it again and again in the Congressional campaigns this fall. What are we to make of that assertion?

In some sense, of course, the mantra is true. Government per se is just an inert set of legal contracts, as is any business. Thus one should really say: “Government and business do not create wealth. The people working in them do.”

If anyone doubts that the people working in government do not create wealth, let them imagine a society without a well-functioning government. Afghanistan immediately comes to mind.

Governments everywhere in modern societies provide the legal and much of the physical infrastructure on which private production and commerce thrive. Imagine a world in which private contracts can be adjudicated and enforced only by private thugs rather than in the civil courts.

Just as sports contests could not be fairly conducted without a strict set of rules and referees with power, so private markets could not thrive without regulations and regulators with power. A truly laissez-faire market economy would be apt to be a mess, as what Wall Street made of its own business in recent years reminds us.

In my lecture on wealth, I went to some length to provide other examples in which government contributes directly to the nation’s wealth and is, indeed, a holder of much concrete wealth on our behalf.

A nation’s wealth is truly a joint creation in which individuals, families, business and government all play crucial parts. Finding just that mix of efforts and regulations that will maximize society’s well-being is a tricky and never-ending quest.

http://economix.blogs.nytimes.com/2010/05/21/who-creates-the-wealth-in-society/

How Businesses Create Wealth (Part 2 of 3)

MAY 7, 2010, 6:00 AM
How Businesses Create Wealth

By UWE E. REINHARDT
Uwe E. Reinhardt is an economics professor at Princeton.

In last week’s post I offered a near metaphysical definition of wealth that set off a lively round of commentaries.

This week I explore how companies create “value” and distribute it among various stakeholders.

That value can be consumed on the spot to produce other goods and services or to create a consumer’s well-being. Alternatively, it can be saved and stored in the form of some asset. Freshman economics texts define an economic unit’s wealth as the market value of all of its assets minus its liabilities. Value creation and wealth are thus related.

Let’s imagine a company called ABC Inc., which produces a standard, ordinary commodity, by which I mean that society does not hold particular ethical strictures on its distribution (as we, for example, do for health care and education). The chart below sketches the value flow caused by the production of some volume of output. (The pipes going in and out of the company are not drawn to scale.)

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Uwe E. Reinhardt

The large pipe in the upper left corner labeled “Gross Value Created” represents the maximum revenue ABC Inc. could have extracted from its customers if each unit of output could have been auctioned off, one after the other, to the highest bidder — an arrangement economists call “perfect price discrimination.” This hypothetical, maximum extractable revenue is the economist’s measure of the “social value” of ABC Inc.’s output.

Evidently, by thus defining social value, economists tacitly assume that rich people, who can bid a higher price for a thing, “value” the thing more than do poor people, even though rich people may not crave it any more than do poor people and possibly even less. It often surprises students that modern economics is solidly based on that legerdemain, which I admit to them in a memo entitled: “How We Economists Bastardized Benthamite Utilitarianism and Became Shills for the Wealthy.”

Leaving aside this important fine point, the sketch is drawn to show that ABC is not able to capture in the form of “sales revenue” all of the gross value it creates.

This is because in most markets, output is sold at a single, common price to all customers, which allows many of them to obtain units of the output at market prices below the maximum bid prices they would have offered in our hypothetical auction. The difference between the two prices is called “buyers’ surplus.” It is a kind of intangible profit that sellers must cede to buyers.

ABC Inc. now distributes the value it captures as “sales revenue” to sundry stakeholders as follows.

Usually the largest fraction is allocated to employees in the form of “employee compensation.” For most employees, the gross value they extract from the corporation as compensation exceeds their so-called “reservation wage.” The latter is the minimum compensation they would have to be paid to attract them to and retain them in the corporation.

This “reservation wage,” of course, is strongly influenced by what the employee could earn in the next best employ — the employee’s “opportunity costs” of working for ABC Inc. — but it also is influenced by how much employees like working there.

The difference between an employee’s actual compensation and his or her reservation wage is the net value employees extract from the corporation. Economists view it as a form of profit, too.

Indeed, it may astound union leaders that many companies bestow more profits of this type on their employees than they bestow profits on their shareholders. It almost surely is so in heavily unionized industries — e.g., the automobile or transportation industries. But it can easily be true even in non-unionized industries.

Brushing lightly over the fraction of ABC’s sales revenue (which is captured gross value) that flows to creditors in the form of interest, to suppliers of non-labor inputs, and to government in the form of taxes, we arrive at a residual that accrues to the owners as “profit available for distribution to shareholders.”

Management and the company’s directors may decide to distribute some of that residual to shareholders in the form of cash dividends. But usually the bulk or even all of it is plowed back into the company in the form of “retained earnings.” Few shareholders take out much of the gross value their companies create in the form of cash.

Wall Street bases its estimate of the company’s “market capitalization” solely on the residual “profit available for shareholders” pipe, eclipsing from view the entire value-flow that accrues to other stakeholders. Unfortunately, many journalists and pundits in the financial press then mistake that “market capitalization” as the sole measure of the “wealth” the company creates, not realizing that this metric can rise or fall for reasons other then genuine value creation by the company.

Suppose, for example, that a company’s volume of output has not changed, but that it somehow manages to raise prices paid by some or all buyers, capturing more of an unchanged gross value created by the company’s output. The company’s market capitalization would be likely to rise as a result of the price increase. But would that add to the nation’s stock of wealth? Or would it merely be a redistribution of wealth from buyers to shareholders?

Similarly, suppose new management takes over and changes nothing other than reducing or eliminating retiree health benefits promised to already retired workers during their working years, albeit in a contract that can be broken (as many such contracts can be broken). If those savings in expenses then flow through to the owners’ profits, the company’s market capitalization would be likely to increase. But is that an increase in national wealth?

I would argue that a corporation contributes to national wealth only if it does something to increase the “total gross value” of what it produces. Someone will then get that added gross value — the buyers in the form of buyers’ surplus or employees in the form of added compensation (perhaps mainly executive bonuses) or the shareholders, and so on.

Regardless of its distribution among stakeholders, and even if none of it flows to the company’s owners, that added gross value can be viewed an addition to national wealth, at least at that moment, before it may be burned up in production elsewhere or on consumption.

http://economix.blogs.nytimes.com/2010/05/07/how-businesses-create-wealth/

Where All That Money Went (Part 1 of 3)

APRIL 30, 2010, 6:00 AM
Where All That Money Went

By UWE E. REINHARDT

Uwe E. Reinhardt is an economics professor at Princeton.

2:50 a.m. | Updated


“We’ve lost almost $11 trillion of household wealth in the last 17 or 18 months,” lamented Senator Christopher J. Dodd, the Connecticut Democrat, on last Sunday’s “Meet the Press,” as he urged Congress to proceed with speedy deliberations on a finance reform bill.

Eleven trillion dollars! That’s over three-quarters of our current gross domestic product.

Where did all this wealth go? Did other folks get it? Or did it just go up in smoke?

For that matter, what precisely is “wealth”? Is it something tangible we can see, or is it something intangible – something merely imagined?

In an illuminating paper on asset values and wealth, the economist Michael Reiter defined wealth in a way that makes sense to economists:

“Wealth” is the present value of the expected stream of future utility [human happiness] that an “infinitely lived individual or a dynasty” [or a nation] could hope to extract from the real resources available now and in the indefinite future, assuming these real resources are allocated and managed now, and over time, so as to maximize that present value of future utils (at the “proper” discount rate).

Two practical points can be extracted from this abstract definition.

First, economists think of wealth not just in monetary terms — as cash, stocks, bonds and real estate — but in terms of human well-being.

Second, and most importantly, the wealth a nation believes itself to possess is based strictly on the citizenry’s expectations about the future. It is in good part a figment of the citizens’ imagination.

To be sure, these imaginations are anchored in the tangible and intangible resources a nation has at any moment and hopes to have in the future. Among these resources are patents and blueprints that represent the current technological state of the art.

But the same set of current resources can trigger vastly different levels of imagined “wealth,” depending on the citizens’ mood.

To illustrate that these are not just the abstract musings of an econ-geek, let us look at the value of something concrete: a building. Here I draw on a tongue-in-cheek paper I once penned for Princeton alumni entitled “How Much is a Building Worth?”

What could be more real and concrete than a building?

Imagine, then, a new building that, fully leased at current rental rates, currently yields the owner $20 million in cash per year, after all of the owner’s expenses of operating and maintaining the building.

Assume the building will be in operation for 40 years, after which it will be torn down at costs that are just covered by selling the land underneath it. That assumption allows us to view the current value of the building to its owner, or to a prospective buyer, as the time-value adjusted sum of the annual net cash flows accruing to the owner(s) over the next 40 years.

The term “time-value adjusted” refers to the idea that, say, $1,000 receivable one year hence is worth less to the recipient than it is now, because something less than $1,000 could be invested today at some interest rate to grow to $1,000 a year hence.

If the relevant interest rate were 5 percent, then $952.31 would do the trick. It would grow to $1,000 in one year. The “present value of $1,000 receivable one year hence at a discount rate of 5 percent” therefore is $952.31. By similar logic, and assuming one could earn a compound-interest rate of 5 percent on money invested for 20 years now, $1,000 receivable, say, 10 years from now has a present value of only $376.89, and so on.

The graph below shows the present value of our building at different discount rates and for three assumed annual growth rates in the annual cash flow from the building. The exercise clearly shows just how sensitive the value of long-lived assets, such as an office tower, is to assumptions about the future. It can explain why Hong Kong real estate values literally fell by half as part of the Asian financial meltdown of 1997.


Uwe E. Reinhardt

The discount rate used in this exercise should be thought of as the rate of return that a prospective buyer of the building would expect minimally to earn on that investment to find the deal attractive. That rate is driven by three key factors:

  • (1) what one could earn on a risk-free investment, e.g., a United States Treasury Inflation Protected Security (also known as TIPs), 
  • (2) the investor’s expectations about future annual inflation rates, and 
  • (3) a risk premium to compensate the investor for the perceived uncertainty inherent in investing in long-lived assets such as real estate.


It is here that mood enters the picture.

If investors are exuberantly optimistic about the future growth of the economy and future rental rates, and if they believe there is little risk in such long-term investments, the risk premiums they demand tend to be low and real estate values correspondingly high. Completely irrational exuberance of the sort we have seen in recent years can easily lead to serious “underpricing of risk” and, thus, to real estate bubbles.

On the other hand, if investors are very pessimistic and worried about the risk inherent in such investments, their risk premiums rise and asset values fall. Irrational despondency can lead to overpricing risk and underpricing real estate.

Now, what is true for real estate also applies to other assets — home values, stock prices, bond prices and so on.

So let’s go back to the lost $11 trillion in wealth lamented by Senator Dodd. Where did it go? For the most part, I suspect, it just went up in smoke. It represents a loss of wealth that once exuberant folks imagined to have had and now imagine they no longer have.

True, with its clever but untoward shenanigans, Wall Street has sucked billions of dollars out of the pockets of hard-working folks on Main Street and transferred them into the financiers’ own pockets. In this connection, merely read these articles to see how it was done.

But they didn’t amass $11 trillion. The bankers did not get that rich.

In next week’s post I will explore who creates a nation’s wealth — businesses or households or government, or all of them?


http://economix.blogs.nytimes.com/2010/04/30/where-all-that-money-went/