Don’t you love those advertisements for Temu that prompt you to start shopping “like a billionaire.”
I get the idea – buying lots of cheap items online might make you feel like you are really awash with cash without spending that much – but in reality, we shouldn’t be trying to spend like a billionaire.
I’m also fairly sure billionaires don’t spend a lot of their time buying piles of plastic crap online.
Where billionaires can be a really useful example is when you look at how they invest and compare that to the average person.
Equity Premium Experts
Billionaires in general are experts in using what is known as the equity premium – one of the wonders of the investing world – to their advantage.
Looking at it simply, the equity premium refers to the excess return generated by shares in companies above the “safe” or “risk free” rate available through other investments such as bonds and cash.
There are many academic arguments about how or why the equity premium is generated but the only thing the investor really needs to know is that historically, shares have provided a return higher than you could get by investing in bonds—at times, a much greater return.
The price that investors must pay to access this premium is volatility, which is a lack of certainty about the price of a share investment at any particular time.
We are now living through such a time of increased volatility, and a likely temporary reduction of the equity premium, as the US-Israel-Iran war continues to frighten investors.
Volatility Brings Big Rewards
Volatility means there are good times to buy and sell shares and bad times to buy and sell, so the investment horizon needs to reflect that.
Volatility can be tough to deal with over particular time frames but if you widen the graph a little to see a longer time frame, the equity premium more than pays for the lack of certainty presented by the bumpy general run up in share prices.
We have all experienced that by living through a variety of financial crises, many of which seemed incredibly dramatic at the time but now are little more than a squiggle on a share market graph.
When you combine the equity premium with the power of compounding you have a seriously potent wealth generation engine.
Billionaires Invest Very Differently
All of this sounds like an interesting theory but not very practical until you look at some of the excellent historical research produced by Goldman Sachs using US Federal Reserve figures to compare the difference between how the top 1% of wealthy Americans invest compared to the bottom 50% by wealth.
The figures would probably be a little different in Australia – I suspect our billionaires are a bit heavier on property and mining – but similar enough to make the point.
What the research found was that the top 1% – effectively billionaires and almost billionaires – had a dramatically different asset allocation compared to the “average” American.
61% of Billionaire Wealth is in Shares
The average amount that they had invested in shares was a staggering 61%, concrete evidence that the very wealthy have used and continue to use the equity premium and the power of compounding returns over time to grow and maintain their wealth.
It only makes sense when you consider that someone like Elon Musk has the vast bulk of his wealth tied up in shares in his companies—a situation common to many billionaires.
In many cases billionaires have founded their own companies and own large slabs of them while others simply invest in a variety of companies.
What about the Bottom 50%?
As you might expect, just 4% of poorer household wealth was tied up in shares, keeping exposure to the equity premium at a very low level.
That number is likely higher in Australia due to our excellent superannuation system which automatically sets aside 12% of earnings for retirement which often has a large percentage invested in international and domestic shares.
Instead, the bottom 50% in the US had the majority of their wealth – 55% - tied up in real estate.
That probably makes sense in some ways for poorer households who are trying to keep a roof over their heads as a basic building block for their wealth.
This is also not to say that real estate is a worse investment than shares – on some ten-year comparisons in Australia it has outperformed shares – but for the purposes of investment here there are plenty of problems with it.
Most real estate owned by the bottom 50% would be subject to loans so it actually costs money to keep and even if that makes financial sense compared to renting, in cash flow terms it is performing more like a liability than an asset.
Property is also hit by a raft of taxes and costs from stamp duty and rates to maintenance and land tax.
Shares Have Some Inbuilt Advantages
Shares have several advantages.
They are cheap and easy to buy and sell, they generally have a higher net yield, they have transparent pricing and very little in the way of ongoing costs, can be bought and sold in small parcels and are taxed more concessionally than other income.
This analysis might seem unfair to the poorer households and to some extent it is—clearly, they don’t have the surplus capital to commit to investment and if they aren’t buying a house, they will still need to pay rent.
However, even allowing for that, the way the ultra-wealthy invest is a clear sign that what they are doing works well to build wealth and with their real estate holdings just 11%, the challenge is clear.
Increased Share Allocation Can Mean Big Returns
If the poorer 50% could up their shares component from 4% to 8%, that would make a dramatic difference to the eventual outcome, particularly if they continued to increase that percentage as circumstances allowed.
Potentially, they could also use US versions of superannuation (such as 401K and Roth plans) to multiply the power of the equity premium in a lower tax environment.
Remember, we are talking about asset allocations here, not raw dollars, so it Is possible to change these percentages a little as long as they don’t eat into spending that is absolutely essential for living.
Compounding Quickly Multiplies Capital
With the average return on Australian shares (capital plus dividends) coming in at around 9.4% a year, over time that can compound to be many times what the compounded risk-free return would be—doubling and even tripling the original investment.
That acts as a great hedge against inflation and helps to retain or expand the buying power of the money invested.
Accessing that equity premium is also easier than ever given the broad diversification available through exchange traded funds (ETFs) and listed investment companies (LICs) and the ready access to offshore markets.
The lesson is clear—the higher the percentage of shares in your asset allocation, the wealthier you will become over time.
Those billionaires aren’t idiots, even though some of them sometimes behave like they are.
In an overall sense though, there is little doubt that using a combination of the equity premium and compounding can expand wealth, even if joining the ranks of the billionaires is not even on your wish list.
