Imagine two people of the same age:
- Poor, who has ten thousand dollars, and
- Rich, who has ten million dollars.
Poor has a job. He earns fifty thousand dollars in a year, which isn’t much considering the cost of living. But Poor is frugal and manages to save five thousand dollars each year. He is also prudent, and invests in a low-cost target date fund (for people who plan to retire by a certain future date). This target date fund returned 5% last year.
Rich earns half-a-million dollars every year. Despite being rich, he is also very frugal. He saves four hundred thousand dollars each year, or 80% of his salary! He invests his savings in the same fund as Poor.
In the beginning, Rich was a thousand times richer than Poor (ten million vs. ten thousand). What happens after one year?
| Rich | Poor | Rich: Poor Ratio | |
| Initial wealth | $10,000,000 | $10,000 | 1,000 |
| Earnings | $500,000 | $50,000 | 10 |
| Year’s savings | $400,000 | $5,000 | 80 |
| Investment gain | $500,000 | $500 | 1,000 |
| Final Wealth | $10,900,000 | $15,500 | 703 |
| Wealth growth rate | 9% | 55% | 0.16 |
In one year, Rich earned and saved a lot of money. Poor earned and saved little in comparison to Rich. But because Poor had very little wealth to begin with, his savings were a much larger percentage of his wealth. As a result, even though Rich earned a lot more, and was very frugal, his wealth only grew 9%. And despite investing in the same fund as Rich, which produced only a modest return of 5%, Poor’s wealth grew a stunning 55%. In just one year, their wealth ratio dropped from 1000 to about 700.
If the rich and the poor in a country behave like Rich and Poor, wealth inequality will naturally go down. This is a basic conclusion, and a reason for hope.
Generally speaking, wealth grows in one of two ways:
- Saving
- Return on investing
Final Wealth = Initial Wealth + Saving + Return on Investing
For the rich, savings from earnings are usually a small fraction of their wealth. This is what happened to Rich. For this reason, it is hard for the rich to become much richer through saving. Instead, the rich grow richer through investment returns. The poor, on the other hand, can grow their wealth rapidly through savings in addition to investing. That’s what Poor did in the example above.
The lesson of the above thought exercise is: In the beginning of your journey of wealth, earn and save! The math shows that investment return (as long as it is not negative) matters little to the growth of wealth when one begins their journey of wealth.
Why is it then that we hear that the rich are getting richer and the poor are getting poorer?
First, what we hear is true. The following is a quote from a 2021 paper published in OECD Policy Insights:
“.. the wealthiest ten percent of households own over half of all household wealth, a share that has increased since 2010 in two-thirds of the countries ..
OECD (2021)
.. At the other end of the spectrum, households in the bottom half of the wealth distribution own little to no net wealth.”
Moreover, extreme wealth inequality is dangerous for the poor and the rich alike. Studies such as one by Ray Dalio, founder of Bridgewater, have argued that extreme wealth inequality coincides with the rise of populist leaders. When a majority of the people lose faith in a system of government, believing instead that the system is rigged against them, they then support leaders who will tear the system down.
But why is inequality growing when the math shows that the poor can bridge the gap? There are two possible reasons:
- When the poor cannot or do not save, and
- When the rich achieve superior investment returns.
Let us look at reason 1. It is clear that the poor are not saving. If you scroll up to the quote from OECD(2021), it says that the bottom half of households “own little to no net wealth”. This is an unsettling truth.
It is hard for a poor person to save. In the example I gave, Rich seems very frugal. For someone so rich, saving 80% of his income is indeed frugal. But it took more sacrifice for Poor to save five thousand dollars from his fifty thousand salary. The poor also lack a safety net, so even a small accident or emergency can reset their progress. Corporate entities use advertising to encourage buying of their products, which encourages spending. The media, which depends on attention for its survival, highlights flashy spending behavior. Are the poor being coaxed to remain poor? Perhaps they are. The adage “the rich get richer and the poor get poorer” attributed to the poet Shelley has carried the ring of truth for a long time.
Now, let us look at reason 2, which says that the rich achieve higher investment returns. This is also unfortunately true. In an paper titled Heterogeneity and Persistence in Returns to Wealth, researchers studied how investment returns depend on wealth. The study was based on data from Norway, but the main takeaways should be general. The paper says: “returns are positively correlated with wealth: moving from the 10th to the 90th percentile of the net worth distribution increases the return by 18 percentage points”. In other words, they said (see Figure below) that the richest group achieved 18% higher return than the poorest group! In the long run, investment returns over 10% are rare regardless of wealth. If the difference between the very rich and the very poor is 18%, it means that the poor experience negative return on wealth, or “become poorer”. Shelley had it figured out!
The rich do indeed achieve higher returns, but this is not because the poor don’t have access to good investments, at least not in the United States. The American financial system has many low-cost diversified investment products. These products are available to everyone. The barrier is that identifying suitable investments requires some guidance. The financial planning and investment management industry is not incentivized to serve the poor. Compensation results almost exclusively from serving the rich. There is insufficient economic incentive, and a large penalty in time and in effort, to serve the poor. As a result, the poor are more likely to fall prey to crooks posing as investment experts.
From a societal perspective, there are steps that can be taken to ensure that the poor save and consume a healthy investment diet. Solutions are possible through government as well as through philanthropy. In each case, there will be challenges in executing, but the hurdles are not insurmountable.
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