IN JANUARY 1963, Warren Buffett included an impish observation in his letter to his investment partners: "I have it from unreliable sources that the cost of the voyage Isabella underwrote for Columbus was approximately $30,000," he wrote.
Unreliable indeed: there was no dollar in 1492. But we get the gist. Buffett goes on to observe that while the voyage could be seen as "at least a moderately successful utilisation of venture capital", if Queen Isabella had instead invested $30,000 in something yielding 4% compound interest, the invested sum would have risen to $2-trillion by 1962.
For her inheritors’ sake, perhaps Isabella should have said no to Columbus and simply founded the 15th-century equivalent of a passive index fund instead.
Buffett’s thought experiment came back to me as I perused the latest list of billionaires from Forbes. None of the leading players had achieved their position by the simple accumulation of family wealth over generations. The top five — Bill Gates, Amancio Ortega, Buffett, Carlos Slim and Jeff Bezos — are all entrepreneurs.
According to economists Caroline Freund and Sarah Oliver, the proportion of billionaires who inherited their fortunes has fallen from 55% two decades ago to 30% today.
Is this absence of old-money billionaires because Buffett’s 4% compound interest was unavailable to the wealthy and powerful of pre-industrial Europe? Hardly. If anything, 4% is conservative.
According to Thomas Piketty’s best-selling Capital in the Twenty-First Century, the real rate of return on capital, after taxes and capital losses, was 4.5% in the 16th and 17th centuries, then 5% until 1913. Although it fell sharply between the wars, the effective average rate of return was very nearly 4.3% across the five centuries. At that rate, $30,000 invested in 1492 would be worth $110-trillion today.
Not to get too technical, but $110-trillion is a lot of money. It’s more than 1,000 times the wealth of the world’s richest man, Gates. It’s 17 times the total wealth of the 1,810 billionaires on the Forbes list — or nearly half the total household wealth on the planet.
(According to Credit Suisse, total global household wealth is $250-trillion.)
Queen Isabella’s investment advisers apparently let her down. Patient, conservative investments would have left her heirs today with a fortune to tower over every modern plutocrat.
All this brought to mind Piketty’s rg, a mathematical expression so celebrated that people started putting it on T-shirts. It describes a situation where "r" (the rate of return on capital) exceeds "g" (the growth rate of the economy as a whole).
That is a situation that described most of human history but not, notably, the 20th century, when growth rates soared, while capital had a tendency to be nationalised, confiscated or reduced to rubble.
And rg is significant because if capital is reinvested and grows faster than the economy, it will tend to loom larger in economic activity. And since capital is more unequally distributed than labour income, rg may describe a society of increasingly entrenched privilege, where wealth and power steadily accrue in the hands of heirs.
This is a fascinating (and worrying) possibility. But it is a poor description of the modern world. For one thing, when billionaires divide their inheritance, mere procreation can be a social equaliser. Historically, the great houses of Europe intermarried and concentrated wealth in the hands of a single heir. (No wonder: one of Queen Isabella’s grandsons, Ferdinand I, had 15 children.) But these days, disinheriting daughters and second sons is out of fashion. (That said, "assortative mating", the tendency of educated people to marry each other, is back and may explain more about rising income inequality than we realise.)
Another thing: the rich do not simply wallow in money vaults like Disney’s Scrooge McDuck. They spend. According to Harvard economist Greg Mankiw, "a plausible estimate of the marginal propensity to consume out of wealth, based on both theory and empirical evidence, is about 3%."
Instead of 4.3% then, wealth compounds at 1.3% after allowing for this spending.
Five centuries of compound interest at 1.3% turns $30,000 into about $25m — not the kind of money that will get you near the Forbes list.
Of course, inherited privilege shapes our societies, not only among the plutocracy, but also down in the rolling foothills of English middle-class wealth. There, economic destiny is increasingly governed by whether your parents bought a house in the right place at the right time — and by the UK government’s astonishing abolition of inheritance tax on family homes.
But whether megawealth in the 21st century will be driven by the patient accumulation of rent on capital, rather than the disruptive entrepreneurship of the late 20th century, remains to be seen.
Long-term real interest rates in advanced economies have fallen steadily from 4% to 5% three decades ago to nothing at all today. You don’t need to be Buffett to figure out if you want to get rich by accumulating compound interest of zero, you’ll wait a long time.
Financial Times
Warren Buffett. Picture: REUTERS/JIM YOUNG
IN JANUARY 1963, Warren Buffett included an impish observation in his letter to his investment partners: "I have it from unreliable sources that the cost of the voyage Isabella underwrote for Columbus was approximately $30,000," he wrote.
Unreliable indeed: there was no dollar in 1492. But we get the gist. Buffett goes on to observe that while the voyage could be seen as "at least a moderately successful utilisation of venture capital", if Queen Isabella had instead invested $30,000 in something yielding 4% compound interest, the invested sum would have risen to $2-trillion by 1962.
For her inheritors’ sake, perhaps Isabella should have said no to Columbus and simply founded the 15th-century equivalent of a passive index fund instead.
Buffett’s thought experiment came back to me as I perused the latest list of billionaires from Forbes. None of the leading players had achieved their position by the simple accumulation of family wealth over generations. The top five — Bill Gates, Amancio Ortega, Buffett, Carlos Slim and Jeff Bezos — are all entrepreneurs.
According to economists Caroline Freund and Sarah Oliver, the proportion of billionaires who inherited their fortunes has fallen from 55% two decades ago to 30% today.
Is this absence of old-money billionaires because Buffett’s 4% compound interest was unavailable to the wealthy and powerful of pre-industrial Europe? Hardly. If anything, 4% is conservative.
According to Thomas Piketty’s best-selling Capital in the Twenty-First Century, the real rate of return on capital, after taxes and capital losses, was 4.5% in the 16th and 17th centuries, then 5% until 1913. Although it fell sharply between the wars, the effective average rate of return was very nearly 4.3% across the five centuries. At that rate, $30,000 invested in 1492 would be worth $110-trillion today.
Not to get too technical, but $110-trillion is a lot of money. It’s more than 1,000 times the wealth of the world’s richest man, Gates. It’s 17 times the total wealth of the 1,810 billionaires on the Forbes list — or nearly half the total household wealth on the planet.
(According to Credit Suisse, total global household wealth is $250-trillion.)
Queen Isabella’s investment advisers apparently let her down. Patient, conservative investments would have left her heirs today with a fortune to tower over every modern plutocrat.
All this brought to mind Piketty’s rg, a mathematical expression so celebrated that people started putting it on T-shirts. It describes a situation where "r" (the rate of return on capital) exceeds "g" (the growth rate of the economy as a whole).
That is a situation that described most of human history but not, notably, the 20th century, when growth rates soared, while capital had a tendency to be nationalised, confiscated or reduced to rubble.
And rg is significant because if capital is reinvested and grows faster than the economy, it will tend to loom larger in economic activity. And since capital is more unequally distributed than labour income, rg may describe a society of increasingly entrenched privilege, where wealth and power steadily accrue in the hands of heirs.
This is a fascinating (and worrying) possibility. But it is a poor description of the modern world. For one thing, when billionaires divide their inheritance, mere procreation can be a social equaliser. Historically, the great houses of Europe intermarried and concentrated wealth in the hands of a single heir. (No wonder: one of Queen Isabella’s grandsons, Ferdinand I, had 15 children.) But these days, disinheriting daughters and second sons is out of fashion. (That said, "assortative mating", the tendency of educated people to marry each other, is back and may explain more about rising income inequality than we realise.)
Another thing: the rich do not simply wallow in money vaults like Disney’s Scrooge McDuck. They spend. According to Harvard economist Greg Mankiw, "a plausible estimate of the marginal propensity to consume out of wealth, based on both theory and empirical evidence, is about 3%."
Instead of 4.3% then, wealth compounds at 1.3% after allowing for this spending.
Five centuries of compound interest at 1.3% turns $30,000 into about $25m — not the kind of money that will get you near the Forbes list.
Of course, inherited privilege shapes our societies, not only among the plutocracy, but also down in the rolling foothills of English middle-class wealth. There, economic destiny is increasingly governed by whether your parents bought a house in the right place at the right time — and by the UK government’s astonishing abolition of inheritance tax on family homes.
But whether megawealth in the 21st century will be driven by the patient accumulation of rent on capital, rather than the disruptive entrepreneurship of the late 20th century, remains to be seen.
Long-term real interest rates in advanced economies have fallen steadily from 4% to 5% three decades ago to nothing at all today. You don’t need to be Buffett to figure out if you want to get rich by accumulating compound interest of zero, you’ll wait a long time.
Financial Times
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