In Bernstein’s “Four Pillars of Investing” he talks about how superstar fund managers often attract more and more money, such that they can’t get the returns they were making in the past (since to buy the “good deals”, in the quantities they need, would drive the price up before they could buy as much as they wanted).
Consider a widget that is worth $30 and we find a supply of them in a store for $10. Say we can only buy them one at a time, and as we buy them the owner increases the price by $1. We’re very happy with this situation if we only have $10 (we buy one, sell it for $30 and go and buy ourselves an ice cream with the $20 profit). Say you have $50,000 instead. You’ll buy 20 widgets, at which point they cost $30 each to buy (so aren’t worth buying any more). While we’re happy that we got some good deals, we got a slightly worse deal with each widget we bought (we only saved $1 on the last one). On this transaction we spent $390 to make $600. Good deal, but probably not the best way to invest $50,000.
I think there’s a great deal of this in life generally. Often the first $1 we invest gives us the best return, provided we’re knowledgable and making rational choices instead of investing in Pro-line. Say I’m on the verge of bankruptcy and am paying 96% annually on a payday loan. If I pay down that loan by $1, I’m making an amazing 96% ROI! Say I pay off the payday loan and put $1 to a 26% Mastercard debt, a 26% ROI is pretty hard to find too! Someone who has no investments or debt can be VERY focused on any investment he makes. Say he buys some materials, builds crafts with them, then sells the crafts. He can probably make a good ROI on this (it wouldn’t be so good if you factored in his time, but if you just look at it in terms of dollars and cents its probably going to be quite good). My mother is a retired teacher and likes to knit. If she were ever going to sell a sweater she made, she’d do very well looking at it from the perspective of how much the sweater is worth vs. what the wool cost her. HOWEVER, as soon as she factors in her time, it becomes a VERY expensive sweater (no one would buy it).
That’s the other advantage of people just starting out, their labour is probably not very valuable, so they can pursue high-labour strategies to pump up their ROI. As your networth increases, the time you can devote to growing each dollar decreases, and you get a diminishing return from any such effort (it’d be a lot easier to work at a crappy job if the alternative was starving on the street instead of working for a newer model Porsche).
Obviously its better to be in the situation of earning investment income from more money instead of less (I’d much rather have $100,000 invested at 5% then $1,000 invested at 7%). My only point with this post is that when you’re starting out, you have a labour “competitive advantage” over wealthier investors. People who take advantage of this by looking for “hands-on” investment opportunities are probably quite smart (they’re avoiding competition from the rich people).
I looked all over for a definition of competitive advantage (from economics), but couldn’t find one (anyone have a link?). I wrote up a quick post explaining it here.
{ 4 comments… read them below or add one }
Interesting post.
I’m not sure how this logic applies to personal investing since most of us can’t buy enough stocks to change the market unlike a large investment fund.
This reasoning definitely applies to debt (ie pay off high interest first) and I also apply this exact logic to saving money.
For example I saved about $20/month on my car insurance by increasing the deductible from $300 to $1000. All I had to do was make a 5 minute phone call so the effort was minimal compared to the savings.
Unfortunately there aren’t too many easy money saving opportunities like that!
Groceries is another area I’d like to save a bit of money but even there, I could probably reduce the bill by 5% fairly easily. The next 5% would involve a bit more effort and to reduce it more than that would involve a lot more effort or a change in the type of groceries I’m buying.
My attitude is to get the easy 5% savings and then look in other areas for other possible “easy” 5% savings. Once I’ve gotten all the “easy” 5% savings then I can think about going to the next level.
Mike
Mike: Consider flipping a houes. Say you’ll purchase the house for $100K, put in 100 hours of labour into it and make a profit of 10% selling it in 3 months after all expenses.
Now consider 3 investors, Dirt Poor Dan, Mediocore Marvin and Filthy Rich Frank.
Marvin has exactly $100K, buys the house, puts in the 100 hours and earns a 40% ROI (since he got a 10% return in 3 months).
Frank has $1M to invest, and can’t be bothered to put in 100 hours of his time for a dinky $10K (he’s a lawyer and could earn more then that from working 100 hours billed at $150 / hour). He thinks its a good deal though, so he buys the place, and offers someone half the profit to do the work. He makes a 20% ROI ($5K profit on $100K investment in 3 months).
Dan is the one Frank hires to do the work. He only has $100 to invest, which he does, then puts in the 100 hours of work (Frank does his best not to laugh when he’s handed the check for $100). Dan ends up making a ROI of 200% ($5K profit on $100 investment in 3 months) .
Obviously the difference in each situation is that value of that persons TIME (Dan’s time is worth the least, Frank’s is worth the most). However, ROI is return on INVESTMENT (where we ignore the value of time – which we usually do, how often do you factor in your time researching stocks in its return?). This gives people with less money an advantage in that they could put more time into a deal to boost the ROI (basically selling their labour for an equity stake in this situation).
Other situations where you could do similar things is buying a franchise with a partner and you actively manage it (so they put in more cash to make it “equal”), pursuing investments that require lots of time (flipping, hunting for bargain properties, ebaying, etc), investing your labour in something you’re buying and selling (the sweater knitting example), spending lots and lots of time analysing stocks to try to find the “deals”, etc.
Apparently with penny stocks (not something I’d ever get involved in), its actually quite easy for small investors to change the market (and that’s the whole game at that level supposedly).
The basic idea of this post (which perhaps I didn’t articulate very well) is you can put labour into an investment to increase your returns (in many cases). For people with less capital, its “easier” for them to do this for a set amount of money (I’d be willing to put all my time towards growing $100 if it was all my money in the world, but I wouldn’t be willing to put much time into a $100 investment if I was Bill Gates).
Another way of saying this might be rich people pursue passive investments, poor people (like me) pursue active investments and this is smart in both cases. The poor people *SHOULD* invest labour to get the higher returns. As you accumulate more capital, increasingly passive strategies make more sense.
Bill Gates is nuts for going into work every day. He’s investing his time to grow his capital, which is totally irrational (since he has enough capital to satisty almost every possible desire he might have for the rest of his life). Clearly he’s not doing it for the money.
If you can maintain your lifestyle with a 4% return on your savings, you don’t have any MONETARY reason/incentive to work.
Sorry if I’m still not expressing this as well as I could be (if anyone gets what I’m trying to say and can express it more clearly, please feel free to take a shot at it!
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Just reread your post and I think I understand what you are getting at. Your writing is fine, in this case the problem is with the reader
One other comment about investments – a person who is just starting out and doesn’t have much money to invest could very well get a higher rate of return than a richer person who doesn’t have the time to research their investments but it might not matter very much if the portfolio is small. In that case the $$ difference in the higher return might be peanuts and the poorer person might be better off just getting a part time job or working on saving money somehow – even if the ROI is less, it might result in more actual $$.
Mike
Absolutely! Below a certain point of capital, putting your energy into a job instead of investment is exactly what people should be doing (which is basically what Dan is doing in my example). This is one of the extremes of exactly what I’m talking about (and Bill Gates is the other extreme where he has no business working
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I’d go so far as to say if you have any consumer debt, the best focus for your “money making” energy is employment. Starting businesses and passive investment are for people who have extra-money, not for people deep in debt.