A Simple Secret to Staying Rich
In last week’s portfolio review I talked about exponential growth, the power of compounding and the concept of “doubling times.”
Today, I want to introduce you to a simple way of staying rich – a way to guarantee better overall returns for your portfolio without even thinking about the stock market.
If you haven’t read last week’s review yet, I’d encourage you to take a look now, as we’ll be coming back to these themes again in future. There are important investment implications that will help guide our long term investment strategy.
To recap, doubling times measure the number of years for something to double in size. The important thing to remember is that doubling your yearly profits does not halve doubling time for your investments. The relationship is non-linear.
As a reminder, here’s the chart I used last time that shows the doubling times of anything growing at a constant rate. The percentage rates of growth are shown along the horizontal axis, from 1% to 10%. The doubling times, in years, are on the vertical axis.
You can clearly see from this chart that as the growth rate increases the doubling time reduces. Move from 2% a year to 3% a year and the doubling time falls from 35 years to 23.3 years. If you add another one percentage point of growth, you reduce the doubling time by 11.7 years – or 33% of 35 years.
But as the growth rate increases, each additional increment of growth reduces the doubling time by a lesser amount. Move from 3% a year to 4% a year, and your doubling time comes down from 23.3 years to 17.6 years. That’s a reduction of just 5.7 years and only 24.4% of 23.3 years.
This has critical implications for your long-term investment strategy. Increasing your average yearly returns will always improve long-term performance and reduce the doubling time of investments. But it’s much more valuable to get those early improvements than to squeeze out the last few additional percent.
Keep Costs Low and Profits Will Follow
Keeping costs down is one of the easiest and most powerful ways to improve long-term performance and grow wealth quickly. It can seem like a drag (which is why most investors don’t bother). But it is highly effective at improving long-term returns.
This includes trading costs such as commissions. It also means that high-cost investment products such as hedge funds, private equity funds and structured products are likely to damage the performance of your portfolio over the long run. Most of the time their high fees will outweigh any real, or perceived, advantages of their investment strategies.
Our investing approach is designed to keep costs low. First, we avoid expensive products. Second, we trade infrequently. This is because we don’t change our asset allocations often. And we don’t over diversify.
You can also keep costs down using the “hard structures” we recommend at Bonner & Partners – trusts, wills, tax efficiencies, etc. Thanks to the power of compounding, these will make a huge improvement to your portfolio’s doubling time.
In fact, high fees for tax lawyers and accountants often represent excellent value for money when viewed in this way. (Just don’t tell the lawyers and accountants.)
Taxes are usually a percentage of gross investment profits (sometimes they can be wealth taxes, calculated as a percentage of total value). Your individual tax rate on your investments depends on a number of key factors:
- Your nationality (for US citizens especially, who are taxed globally).
- Your country of residence (most non-US citizens pay local taxes where they live, not where they come from).
- The size of your income coming from other sources, such as a salary. (If you already earn a big salary then chances are you pay top rate tax on investment income. If you are retired then the tax on your investments could be much lower.)
- Your tax planning strategies and structures (including tax-free vehicles like pension funds)
- Whether your investment profits come from income (stock dividends and bond coupons) or from capital gains (price rises between purchase and sale)
- Whether you have to pay a wealth tax each year on all your assets
- How long you hold your investments for (sometimes taxes on capital gains are lower for longer-term investments)
- Where you are investing (for example, some countries deduct withholding taxes on locally listed stock dividends at source, but this is often deductible against taxes in your home country)
Your Wealth Is a Soft Target
Because so many factors are in play, it is difficult to generalize when it comes to personal tax situations. Each of you will face a different set of circumstances and rules. But we can guess at the direction that investment taxes are heading for most of us. Up.
Governments create the tax code. It’s a fair bet that investment taxes will rise over the coming years, as bankrupt governments scrabble around for additional income. This is because financial wealth is highly concentrated in the hands of a small percentage of the population. Wealthy people are easy targets – they have a lot of money, but they don’t have a lot of votes.
This makes investment portfolios a soft political target. It also means keeping taxes (and costs) down will become even more important in future.
What concerns us as legacy investors is by how much our investments beat taxes and inflation over the long run. The shocking part is that most mainstream investment strategies don’t achieve this. (And it’s why the mainstream investment community is virtually silent on how official inflation rates are understated. It makes them look better.)
This has major implications for growing family wealth…and for how quickly you do it. Doubling times are very sensitive to whether your net investment returns are, on average, low to mid-single digit percentages or low to mid teens.
Introducing Andy, Bob and Catherine…
I’ll call profits after inflation and taxes your “net real profits.” The “gross nominal profit” is what you make before taxes and inflation. Net real profit over time is the gross nominal profit less taxes less inflation.
Imagine three investors called Andy, Bob and Catherine. They all live in the same country. And they each have the same amount of money to invest, the same lifestyle, the same inflation rate and the same tax rate.
The amount of tax they each pay, in dollars, will depend on the size of their gross nominal profits. But the inflation deduction, to work out their net real return, will be the same in all cases.
Let’s say inflation is 5% and the tax rate is 20%.
Andy makes 6% gross nominal profits. Taxes take away 1.2% (20% of 6%) leaving 4.8%. Inflation takes away another 5%, leaving a net real loss of 0.2%. If Andy continues like this his wealth will be worth less in future. If taxes go up and gross nominal profits don’t improve, he will lose a lot of money over time.
Bob makes 8% gross nominal profits. Taxes take away 1.6% (20% of 8%) leaving 6.4%. Just as for Andy, inflation takes away another 5%, leaving a net real profit of 1.4%. Bob has grown his wealth.
Taxes could rise to 37.5%, and Bob would still break even after inflation. If nothing changes, his inflation-adjusted wealth will double in just under 50 years. That’s a long time. But at least Bob’s wealth is growing. And if he’s patient, he will have a lot more of it at the end of his life than he had to start out.
Catherine makes 10% a year in gross nominal profits. Taxes take away 2% (20% of 10%) leaving 8%. Net real profit, after deducting 5% inflation, is now 3%. Catharine has a big cushion against tax rises before net real profit would turn negative. And her doubling time is cut to around 23.5 years.
You see what happened here? Andy loses money at 6%. Bob makes money at 8% and doubles his wealth in 50 years. But Catherine’s doubling time, after inflation and taxes, is less than half of Bob’s because she made 10% a year of gross investment profit. That extra 2% profit a year makes a huge difference.
We need to take a closer look at the interaction between gross nominal profits, tax rates, inflation rates and doubling times for the resulting net real profits. Using different assumptions we can see how they interact.
Do You See What I See?
The chart below shows this relationship using a fixed inflation rate of 5%. The vertical axis shows doubling times in years. The horizontal axis shows gross nominal profits – the average yearly investment profits after deducting taxes and inflation.
Each line corresponds to a different tax rate on gross nominal profits, assuming the tax rate stays constant over time. The lines start at the first point of gross nominal profits where net real profits are positive for each different tax rate.
We get curves, just like in my earlier chart. I’ll pick a couple of data points to help explain the chart. On the red line, which corresponds to 10% taxes on investment profits, take a look at the doubling times for 6% and 7% gross nominal profits.
At 6% gross nominal profits the net real profit is 0.4%. This is 6% less 0.6% tax (10% of 6%) less 5% inflation. This means the doubling time, after taxes and inflation, is 175 years. (Remember the rule of thumb for doubling times is 70 / rate of growth.)
At 7% gross nominal profits the net real profit is 1.3%. This is 7% less 0.7% tax (10% of 7%) less 5% inflation. This means the doubling time, after taxes and inflation, is 53.7 years.
So at 10% tax and 5% inflation, moving from 6% to just 7% gross investment profit has slashed the doubling time from 175 years to 54 years.
Obviously, for the same gross investment profit, doubling times increase as taxes go up. That’s because there is less net real profit left over.
Someone who enjoys no taxes on capital gains or income (such as a non-US citizen living in Hong Kong) can earn 7% gross investment profit. And their doubling time will be 35 years. Someone paying 40% tax on their investments (possible in parts of Europe) would need to earn 12% gross to double their real wealth in under 33 years, a similar time frame.
Tax havens are suddenly very appealing.
Of course, all these figures are calculated using a fixed 5% inflation rate. If inflation is lower then doubling times reduce, and vice versa.
Your Early Gains Count Most
One thing is clear on all these curves, whatever the tax or inflation rate. The early gains really count.
If you pay low investment taxes then moving from 6% or 7% a year to 9% or 10% a year will make a huge improvement to your doubling time…and to your family wealth. If you pay high investment taxes, achieving 12% or 13% a year gross investment profit will be a world away from just 9% or 10% a year.
To get that kind of return you need to buy well and buy growth. This is why we favor value investing in growth markets, such as emerging markets. It gives us the best chance of superior returns in the long run.
But the curved relationship also means we don’t have to over-extend ourselves and take on excessive risk to improve our doubling times. We can do just enough to pick the low hanging fruit of the curved relationship between profits and doubling times.
Treasury Yields at a 112-Year Low!
All of this brings me back to my least favorite asset class – bonds.
The 10-year US Treasury bond has been in a 30-year bull market, as you can see from this chart (which shows the 10-year T-bond yield).
Yields are now ultra low and in line with a 122-year monthly low. And I suspect that long-term holders of these bonds are set for ultra low returns too.
Any investment portfolio with a large allocation to low yielding Treasury bonds is doomed to suffer from frustratingly low real net profits. And therefore frustratingly long doubling times for their wealth. In fact, I believe treasurys are destined to lose money (in real terms after taxes) with anything less than severe and prolonged price deflation.
When these bonds mature, bondholders expect to get back the original loan, known as the principal. So the government has to find the cash to make this payment, which it usually does by issuing new bonds.
When a government issues debt it fixes a coupon amount. For example Britain has issued bonds in the past with a coupon of 5% that now have remaining maturity of six years and seven months. For every £100 borrowed the British government has to pay out £5 a year in interest payments.
But since then bond yields have fallen. This means bond investors will accept lower yearly interest rates. If you bought the original bonds, you are still making 5% on the original loan. But if you bought that same bond now – with six years and seven months until maturity – you’ll get a 1.26% yield to maturity.
But how can this be if the government is still paying out £5 interest on a £100 loan?
It’s because the price of the bond has risen to £122.39. The new bond buyer gets £5 a year – or about £33 over six years and seven months (depending on coupon payment timings and terms). But the price will fall to £100 at maturity, meaning an offsetting loss of £22.39. So the net profit over six years is £10.61. (This is 8.7% of the market price of £122.39 and equivalent to 1.26% a year, with compounding.)
When the bond matures the British government will borrow more money to pay back the original loan. At current market prices it can borrow for 30 years at 3.2%. (Talk about having faith in the government! Or a bond market manipulated with QE.). London’s interest cost would actually go down in this example.
I’ve deliberately picked an example where the original coupon rate was different to the market yield to maturity to explain the concept. But what happens if the reverse is the case? What happens if governments have to refinance maturing bonds at higher rates?
In this case the government ends up with a higher interest cost. If it is already running a budget deficit, the deficit will increase (unless it raises taxes to make up the difference). And it will need to find even more new loans just to pay the higher interest costs. This can lead to a vicious circle.
High debt-to-GDP ratios can point to a government having a solvency problem. But a high proportion of short-term debt can point to a government having a liquidity problem. That’s because it has to attract new bond buyers to pay off the old ones. If there is an oversupply of new bond issues in relation to demand from buyers, coupon rates have to rise to bring in the money. This adds to interest costs.
Welcome to “Europa”
To explain this further I’ll use a simple example.
Imagine a country with annual GDP of €100 and a growth rate of 0% a year. Let’s call this country “Europa.” All Europa’s debt has a one-year maturity and 5% yield. The debt is €100 at the start of the year. So the interest cost is €5 a year. And the government debt-to-GDP ratio is 100%.
Europa’s budget deficit, meanwhile, is €10 a year – or 10% of GDP, taking the €5 interest cost into account. The non-interest cost of €5 is flat due to austerity measures, which means it is falling in inflation adjusted terms.
After one year, the debt must grow to €110 – up 10%. The government must borrow €10 to cover the budget deficit. And the €100 of existing debt must be refinanced. The government debt-to-GDP ratio has now grown to 110%.
Bond buyers decide that the government finances have deteriorated and demand a 7% coupon on the new debt. The government’s interest cost now rises to €7.70 (7% of 110). And its budget deficit now rises to €12.70 (€5 plus €7.70) – or 12.7% of GDP.
The following year the debt has increased to €122.70 – up 11.5%. It has grown faster than the previous year, in other words. And Europa’s debt-to-GDP ratio is now 122.7%. (Remember GDP is still €100.)
Seeing this, bond buyers decide that they want a 10% coupon on new one-year debt to compensate for the default risk. The government rolls over. And the interest cost rises to €12.30. The budget deficit rises to €17.30 (€12.30 plus €5), which is now 17.3% of GDP. And so on…
This is a compound debt trap.
Sovereign Debt Is on a Short Fuse
This is an extreme example. But you get the picture.
Large amounts of short term debt and a high debt-to-GDP ratio can lead to a vicious circle of rising interest payments and rising debt burdens. This is exactly what has been happening in Greece, Portugal, Spain and Italy in recent weeks and months. New debt is getting much more expensive for governments.
In real world bond markets the maturities stretch out for 30 years or more. But if you had to guess, what percentage of your government’s debt do you think it has to refinance in the next three years?
Here is the answer for a selection of the world’s major economies, out to the end of 2014.
- Britain – 23%
- Italy – 39%
- Japan – 47%
- Spain – 48%
- US – 53%
Just think about those figures for a while. Governments of the world’s major developed economies have to rollover trillions of dollars worth of sovereign debt in short order.
Actually, I’ve been a little cheeky here. The figure for the US includes the “intra-governmental debt,” such as the debt issued by Social Security funds. This is non-tradable. But it’s still debt.
This debt will mature only if these funds start paying out more in claims than they receive in contributions. But with the baby boomers starting to retire, this could come about much sooner than is generally expected. Excluding these funds the figure drops to 35%, but that is still high.
8 Macro Headwinds
The developed world’s debt problem wouldn’t be so bad, if it weren’t for eight macro headwinds, each of which has the potential to be deeply destabilizing for the global economy.
- Weak or zero economic growth across the US, EU and Japan. Together these three economic blocs account for 58% of world GDP. All are already deep in debt. And all are running budget deficits and increasing their debt loads.
- Political stalemate in the US, a political circus in the EU and political apathy in Japan. Genuine leadership is absent from developed countries.
- Distressed and deleveraging banks, especially in Europe and the US (I’ll talk about this some more in the future).
- Persistent consumer price inflation in the 3-5% range in Europe and the US, despite the global economic weakness.
- Signs of a forthcoming energy and resource crunch, notably the surprisingly strong crude oil prices this year in the face of a “risk off” mentality amongst speculators.
- Debt piled up at the short end that needs to be rolled over soon.
- Ongoing and large fiscal deficits – meaning more borrowing is required to sustain government budgets. Where are the buyers coming from? We already know China hasn’t bought any US Treasurys in the past year.
- The possibility of a new war in Iran – meaning more military deficit spending in the US (and probably Britain).
The result of this could be something unseen in recent memory: weak or shrinking economies, falling consumer prices and rising bond yields. This would drive up lending costs, such as mortgages, compounding the economic weakness.
Or we could get something different, but still highly toxic: weak or shrinking economies, rising prices (due to money printing and/or energy price inflation) and rapidly rising bond yields. Stagflation for starters…and possibly hyperinflation for dessert.
Are you feeling lucky? You’ll need to be if you are a big investor in government bonds.
Conclusion: Long-term wealth growth is what we want. Short-term wealth protection is what we need. Overpriced and oversupplied bonds are likely to fail on both counts.
Until next week,