Some Thoughts on Capital and Risk

From Ashok Rao’s Inequality of Returns and Reinvestment Opportunity:

– the only real source of long-run returns – is far more skewed than that of wealth ownership. The bottom 95% own all of their wealth in two forms:

Explicitly: Home ownership which forces saving over a period of thirty years.
Implicitly: Social security which acts as a claim on America’s future GDP.

Each of these are invested in low-return (real estate and government bonds, respectively) securities. Diminishing marginal returns for the many are real. But if you’re a billionaire, you have access to the stock market, cleverly managed funds and, most importantly, the right information to make the right investments. One can reach the same conclusion as Piketty when wealth accessible to the broad middle-class is consumed and does face diminishing returns whereas that available to a percent reaching escape velocity does not.

The growth of capital tends to be very uneven and volatile whereas economic growth is more smooth. The rich that own stocks and real estate take enormous risk in exchange for more upside. I keep seeing this ‘use it or lose it argument’ to tax the rich more. The super rich don’t consume in terms of trinkets and vacations, but they tend to invest. The later is necessary for functioning of the economy. But this has higher risk in exchange for higher return.

Vince McMahon’s WWE stock fell nearly 50% last week, meaning he’s no longer a billionaire. The left can rejoince – another oligarch thwarted. But wait- isn’t Pickety’s solution a wealth tax?. How is this possible for someone to lose so much money, unless of course, capital isn’t always monotonically growing, but instead is very volatile and subject to market forces, which is why Vince and many former millionaires and billionaires have seen thier fortunes evaporate, in refutation of Pickety’s warnings of an unshakable oligarchy.

The expected value of capital may be higher, but the idiosyncratic or company specific risk is higher, too. Thus, out of 100 capitalists, all but maybe 10 will go bust even though the expected return on capital is higher than growth. Or a winner take all system. This is because there is a lot of variance in returns to capital as opposed to things like wages and money market accounts.

When a company goes bust, who is on the top of the pecking order in terms of being covered: the workers, the bond holders or the shareholders? The worker, of course. He gets paid first in full, without fail. The owners of capital – the shareholders and bondholders- shoulder all of the loss and maybe get pennies on the dollar, if they are lucky. This happens all the time. The point is, capital has huge risks and huge volatility.

Also, about those special funds available only to high net-worth individuals, after fees, they actually underperform the S&P 500 most of the time. Sometimes they fail, too.