The other day I was contemplating all of the stupid decisions I have made over the course of my life. I think a lot of my bad decisions were made due to a lack of a good framework for what I was supposed to be doing with my life.
For example, I had a certain disdain for making money because it didn’t really represent who I was. So I tried a bunch of random things like becoming a pilot, running for office, playing poker, teaching junior high, etc. Now I find myself in the thrilling profession of patent law (although a big part of me still doesn’t identify as a patent lawyer).
Anyway, while I was thinking about this concept I came across a blog post describing a theory of why poor people stay poor:
The idea, taken from a book by Charles H. Karelis called The Persistence of Poverty, is that poor people experience low and increasing marginal utility.
This might not strike you as a big deal at first. But the concept of decreasing marginal utility is pretty fundamental to how we think about money. We almost always assume that the more money you have, the less the next dollar is going to mean for you. But Karelis argues that the poor are so screwed up financially that they actually have less incentive to make money than other people.
The easy way to think about this is to imagine that you are $20,000 in debt with no assets. If you work in a normal job, half of your $500 weekly paycheck is going to be garnished to pay your debts. You aren’t even close to being able to pay them off, so working hardly even makes sense. Instead you opt for something like a subsistence lifestyle, and you prefer to spend money on things that can’t be taken from you by debt collectors.
The idea is that the poor aren’t really any different from the rest of us, they just find themselves in a situation that encourages behavior that keeps them poor. They aren’t stupid, they are just responding to incentives. The wealthy also experience low marginal utility, but on the other side of the curve. Since a lot of wealth and a lot of debt both result in low marginal utility, the overall effect is similar in some ways (i.e., reduced desire to work).
So this explains why the poor stay poor, but why does the middle class stay middle class? If the “stupid” decisions made by the poor are actually just a product of their incentives, can the same be said for those in the middle?
The marginal utility graph at the top of the post is mostly about incentives to work, and the middle class has plenty of incentive. So why don’t they? The answer, of course, is that they do work. A lot. The thing that keeps the middle class middle isn’t how much they earn, it’s how much they spend.
In the past, before the modern information revolution and global economy, there was basically no middle class. There were rich people (i.e., nobility and landowners), and poor people(slaves, serfs, peasants, etc). Rich people developed all sorts of ways of signaling their wealth. They had nice clothes, comfortable houses and all the rest. There was never any mistaking a poor person for a rich person. And the rich stayed rich as long as they could hold onto their land.
These days there is still a level of elite wealth that most people don’t aspire to. However, to a large extent, everyone can pretend to be rich. We can earn a lot of money and spend it on nice cars, houses, clothes and all that. In fact, our consumer economy is built on everyone using consumption to display status. Things have come so far that even if you consume a lot, people don’t necessarily assume you are wealthy. They think you have a high income.
But wealth isn’t really about high consumption. It’s about how you make your living. If you survive off of an endowment, you are wealthy. If you work for a living, you are middle class. The decision people make that keeps them in the middle class is the choice to display status instead of accumulate wealth.
There is evidence that a household needs something like $75,000/year to be happy. After that the effect of increasing income on happiness goes down considerably. So let’s say that you can draw 5% of an endowment per year without cannibalizing your wealth. Then in order to be wealthy you only need assets of about $1.5 million.
On the other hand, if your income is $75,000 or less you have a pretty strong incentive to spend all of it. After all, that money really is going to make you happier. However, there are a lot of people capable of (or actually) making more than $75,000 who never become wealthy. And there are a fair number of people who were raised wealthy that don’t stay wealthy. That is middle class stupid.
Another thing that keeps people middle class is that even when we do accumulate some wealth, we don’t do a good job of passing it along to the next generation. The problem isn’t just that people don’t provide an inheritance. Even when people do leave an inheritance, they often don’t do it until they die. Their children are already well into the working years (or past them), and have already developed a middle class mindset. Furthermore, you can’t just pass along money. For a family to stay wealthy it must pass along a culture of maintaining wealth. More on that in a minute.
Ok, so previously I mentioned casually that you could consume 5% of your wealth each year without cannibalizing it. Obviously, if you did that and didn’t earn anything you would eat into your endowment (about half of it would be gone after 15 years).
A better solution than just thinking about consumption is to target endowment growth. If you aren’t wealthy, you should probably target a pretty high growth rate in order to become wealthy. For example, you can turn $100,000 into $1 million in 25 years if you increase your wealth by 10% every year.
If you are already wealthy, you just need to match inflation + family growth rate (so all of your descendants are wealthy, too). Let’s say inflation is 2% and your family population growth rate is also around 2%. Then your endowment needs to grow at 4% per year in order to keep up. If you consumed 5% each year, you would need to a return on investment of around 9%. If you aren’t getting this kind of return, you need to cut your consumption or get a job.
One thing to note is that to really take advantage of exponential growth, you want to use wealth level targeting. That is, choose a starting point and a desired interest rate, then calculate where you want to be based on that level. If you go below your line, you need some good years to catch up. The level doesn’t change based on your actual performance. Below is an example based on my own circumstances.
The red dotted line is my target. It looks flat because the time period isn’t that long, but it’s really an exponential function based on my own target growth rate. So far, so good. If I can maintain this for a while, my children won’t be working class. If I had adopted this perspective when I was 18, I wouldn’t have to work now.
I could end here, but there is one more question I want to address. Is working class really so bad? Many people think doing an honest days work for an honest days pay is a good thing. Are they wrong?
Yes, I think they are. Why? The same reason I have for pretty much everything else. Our brain isn’t designed to be under constant economic stress. If you are poor, you are under economic stress because you are constantly under threat of things like having your phone cut off, or losing your house. But if you are in the middle class, the constant threat to your status requires you to stay on the treadmill.
In our evolutionary environment, our ancestors were periodically subject to famine. When that happened, it was terrible and people died. But when there wasn’t famine, people survived with a modest amount of effort (as far as we can tell by observing modern hunter gatherers). There was no way to store wealth, and their status wasn’t constantly at risk.
So my argument is that our brain evolved in an environment where stressful events were periodic and intense. Now we live under constant, low level stress. This is bad. Being wealthy (and thinking wealthy) is the best way to escape it.
Of course, being wealthy brings with it some other challenges. Unfortunately, I am not in the best position to describe all of them. I hear a lot of stories about wealthy people who end up falling prey to addiction and wasting their lives. But most of those I hear about are celebrities, and that’s probably a biased sample. I don’t know too many people whose families have managed their wealth across generations.
What I do have are some theories about how to avoid the shirtsleeves to shirtsleeves fate:
- First, get your kids involved in wealth management early. Make it part of the culture.
- Second, put your wealth in a family fund that is shared among a group of about 3–6 couples (if it gets more than that, the cell needs to split). Use peer pressure among the members of the group to enforce family norms.
- Finally, kick your kids out of the group at a certain age to make them face the world, find their talents, and prove themselves. If they want back in, they need to reapply once they have met some benchmarks and demonstrated their commitment to the family.
Pretty extreme? Maybe, but I think preserving a healthy (and wealthy) family culture is a difficult problem that can’t just be left to chance. Modern America does not teach people to be wealthy. In fact, it depends on a level of middle class consumption that isn’t consistent with wealth creation. But I think our culture of consumption results in an unhealthy level of economic stress, and I think it is completely avoidable.
Plus, when robots take over all of our jobs, opportunities to build wealth through saving income might be slim. At that point, the middle class might disappear and we might fall back into a medieval dichotomy based on those who own robots, and those who don’t.
