“The only people I ever met who got insanely rich from a hedge fund operation were (you guessed it!) the managers of hedge funds.” – Felix Dennis
If you Google “how to get rich”, most of the results talk about how to get rich with compound interest. Put some money in the bank every month, watch it grow, wait a few years or decades… and before you know it, you’re living the high life. Sounds easy, sounds simple.
It’s a lie. It’s nothing but lies, and it always has been. Lies, mostly, by investment managers out to steal your money. (More on that part in a bit.)
To start out, let’s define “rich”. A reasonable bar for “rich” is when you can be upper-class (a nice house, a fancy car, eating at top restaurants) without working. In the US, right now, the amount of money you’d need is about $5 million. (It varies somewhat based on where you live, but $5 million is a nice round number, so I’ll stick with it.) If you invest $5 million, and get a 5% average return, you’ll make about $250,000 a year in passive income, which is enough to pay for first-class plane tickets and all those other nice things.
There’s a big, big, big difference between $1 million and $5 million. People tend to be scope insensitive, so they might be tempted to ignore this difference – any amount followed by “million” just becomes “a lot”. However, ignoring the difference doesn’t make it go away. Very few would dispute that there’s a big, big difference between a job paying $20,000 and a job paying $100,000. But the difference between a McDonald’s worker and a law firm partner is exactly the same as that between $1 million and $5 million, a factor of five. It’s a large gap.
To illustrate why compound interest is a lie, consider this scenario. Suppose you start working at age 25, work for forty years, retire at age 65, and then die at age 90. Every year, you sock away $10,000 in your bank account/market index fund. (Note that for most people, $10,000 a year is a large fraction of income, especially after taxes.) Your investment gets 5% returns, which is about the historical average.
(Yes, 5% is the historical average. This important fact has been lost amid various obfuscations. If you don’t believe it, you can do the math yourself – here are historical stock market prices, here is historical inflation, and here are stock dividend rates. The people claiming 10% or 12% or 15% – it seems to get bigger every year – are either lying, or conveniently ‘forgetting’ about inflation. Anyone who thinks that inflation doesn’t matter is welcome to trade a thousand American dollars for a billion Zimbabwean dollars.)
At age 65, the peak of your net worth, how much money is there? Plug the numbers in, hit Crunch, and it comes out to about $1.3 million. You’re a millionaire! Woot! Now, are you rich?
No. To see why, consider what happens if you take that money and spend it on your retirement, like you were probably planning to. $1.3 million for 25 years equals $52,000 a year. That’s a good retirement, but it’s hardly Mercedes and private yacht territory. You might as well work for the Post Office – you won’t starve, but you also won’t dine with movie stars.
It’s an unfortunate fact that, due to inflation, the word we used to have for rich people (millionaire) now includes mostly ordinary, non-rich people who had the sense to save for old age. If you have a single million, and it’s money you can’t replace if it’s lost or spent, you will have a nice retirement, but you aren’t rich. That isn’t just semantics – if you’re in that category, you can’t sustainably live an upper-class lifestyle, and you probably know it.
So, how did things get this way? Why do so many people talk about the magic of compound interest? Back to those investment managers. Most people, when they save lots of money, don’t buy investments themselves; they hire other people, money managers, to do it for them. These managers buy and sell stocks, trying to get an edge on other managers. In exchange for all that buying and selling, they take a cut of the money managed, typically around 1% a year. 1% may not sound like much, but it’s a lot when it’s 1% of a hundred billion dollars.
Does that 1% management fee help your investment do better? No. On average, over the long haul, paying that 1% fee to buy and sell stocks (active investing) will always get the exact same results as just buying index funds (passive investing). To see why, check out this great argument by Warren Buffett. The only difference is that, in the former case, you’re now out 1% of your money. (Per year.)
So investment managers, naturally, are highly motivated to get as much money into their fund as possible. The bigger the fund is, the bigger their 1%-a-year share of it is, and the more money they’ll make. So, they blanket the Internet, blanket the TV, and blanket the newspapers with all this stuff about getting rich through compound interest. Just put all of your money with us, and you’ll soon be living on Easy Street! If only it were that easy.
For more on how to actually get rich, I recommend the book How to Get Rich by Felix Dennis, which is also quite entertaining. (I have no affiliation with Mr. Dennis.)