The philosophal question : how to beat inflation and tax?
A very dear friend of mine asked me the magical, mystical and almost alchemical question: where to invest to get a reasonable return with a reasonable level of risk? Well there are dozens of books published each month about this charming topic, and there are millions of so called “financial advisors” to help one profile one’s risk aversion and profit expectancy. I will NOT discuss this here. First because I am not an expert in this topic, and second because I have nothing to sell…
The discussion with my friend started as a “what would you do”, and was pretty animated due to a few cocktails followed by two bottles of full-bodied yet subtle Valpolicella wine in an trattoria in Venice. I won’t be able to transcribe the exact minutes of our discussion, but it was basically turning around usual concepts. The ideal investment should allow to:
• Avoid inflation erosion
• Optimize taxation
• Bear reasonable risk
As I am very risk averse when it come to my own money, the one that I won as a member of the upper working class, I was provoking him in depicting my ideal portfolio: 1/3 real estate (preferably undeveloped), 1/3 bonds or monetary products (CDs, or the like), 1/3 shares and a dash of capital risk. I pushed so far as to pretend I could live with ½ CDs and ½ CR! My friend’s answer to this was:
• CDs and bonds do not exceed inflation after taxation
• Undeveloped real estate is taxed and do not deliver any income
• The financial market (which average is used as a benchmark) delivers the best compromise between risk and reward, which is higher than the monetary market.
• Capital risk is, well… too risky.
All of these are very true indeed. The discussion stopped here. The next few days, I couldn’t stop thinking about our discussion. Something is wrong, both conceptually and heuristically. After a few more drinks, I was able to point it out: the financial market does not deliver higher return than monetary market, and if it does, the premium is ground by inflation. In other word, people are expecting a “sufficient return” by which their financial capital should grow, which is, at any given level of risk, a positive net return rate .
Following this principle, at zero risk, the acceptable return should equal inflation. Nobody will be happy with that. Why? Because our common understanding is that, “on a long term, the market is more profitable yet not really more risky, than bonds”. The very same common understanding defines “the market” as the average of the stocks, as a sort of meta-index. That alone would be interesting to discuss, but I am choosing not to . Instead, I will embrace the common sense assumption that it is indeed possible to consider a market average as the market general performance.
The other component is the taxation rate. Let’s consider a rate of 16% on capital gains . It applies to the gross return. The inflation also apply to the gross return. As a result, the necessary rate to beat both inflation and tax is given by the formula (R=return rate; i=inflation rate; t=tax rate), i.e. 2.4% for a 2% inflation. Tax acts in fact as a multiplier of “acceptable return” expectations. As a conclusion, people are demanding that their capital do not decrease by anything but their own ability to make arbitrages or to simply spend it. Inflation and tax are seen as negative environmental effects which have to be balanced by opposite effect of return on investment.
The negative effect of tax is easy to understand: people think they always pay too much, and they want to consider their NET profit. What about inflation? Does it matters the same way tax does?
To go any further, we need to revisit the definition of inflation and why it matters to people. People would like to have the comforting feeling that their capital keeps the same “value” value according to which benchmark? Are we talking about just purchasing power? If yes, we have to consider the ability of people to accumulate goods. For example, after a while, people won’t need to spend the same amount of money since they will be equipped with a theory of durable goods they won’t need to replace. For example, if I bought a Corvette for $51,000 in 2008, I won’t have to disburse cash in 2009 again to replace it. Therefore, from a cash-disbursement point of view, I will have $51,000 less need in 2009 than in 2009. Therefore, my purchasing power mechanically increases by $51,000 between 2008 and 2009 have. If people really mind about their ability to disburse at least the same amount of cash, they will have to take into account their ability to accumulate goods, making it less urgent to disburse for goods they don’t need any longer. In other words, people should consider that part of the capital they are spending is not actually spent, but converted into non-financial capital. From a purchasing power point of view, this non financial capital increases the apparent purchasing power of their financial capital. Non financial Capital shouldn’t be limited to durable goods: services like plastic surgery, travels and even restaurants, is also to be considered as increasing purchasing power, since it is more likely that people, with time, will diminish their consumption of those services (except Michael Jackson or the Schwarzenegger couple). In other words, from an individual purchasing power point of view, the financial amount necessary to ensure an equal standard of living will increase over time following the price increase of goods and services, but will decrease at the same time by the effect of good accumulation and lassitude to consume.
As understood from above, determining the right amount of return will impose to plan several years ahead in term of cash. Why not just consider the CPI as a composite indicator of what is needed?
Because CPI sucks! CPI is manipulated by very intelligent statisticians to reflect the real price of things. For example, they do not compare the price of computers in 2011 to the price of computers in 2012: they factor into it the effect of technical enhancement and subtract it from the price increase. In 2010, we are talking about a 2.5 lbs 12 GHz, 2.5 TB machine for $159. In 2011, the price of the equivalent machine is $175. Will CPI be 110? No, because the $175 machine is only 2.2lbs, but 3.5TB! so our statisticians will come up with an estimated value of $161 for a 2.5 lbs 12 GHz, 2.5 TB machine in 2011, i.e. a CPI of 101.3! Magic! Using the same principle, it is most likely that the future equivalent of your current 2008 Corvette will have a lesser value in 5 years, due to the technical improvements which will occur. Too bad if you don’t need the forward-anti-collision-radar or the weather-link detection device : both come standard! You’ll have to pay for it, but it won’t be part of the CPI. On the contrary, the product meeting the original specs of your 2008 corvette will probably be a cheap Chinese sport car.
I could multiply the examples forever, but you should have a good understanding of the picture by now: CPI does not reflect people’s purchasing power evolution. Two phenomena generate deformation effects: first, the technical progress (and built-in obsolescence) force people to buy more expensive products incorporating more and more features (that is also called “progress”), but, in essence, productivity gains and other fixed cost amortization are commoditizing the vast majority of goods and services.
The third possibility is to use the monetary definition of inflation: inflation is the increase of money in circulation. And it is not actually all bad, since part of it is covering the GDP growth. So the bad inflation which is the one on top and beyond the GDP growth, is the one which devaluate people’s financial capital. Now, following the capitalist idea that financial market reflects economy (and vice versa and all together, the market is efficient), any money creation above and beyond GDP growth generate bad inflation, decreases people capital, and has to be eradicated. Then, how should we consider a financial market which could generate more return than the GDP growth? Inherently, by definition it’ll generate money without economic counter value. In conclusion, any financial market serving more than the GDP growth is generating inflation, which in turn decreases the net value of the financial capital.
Should I say that we just demonstrated that expecting financial return above GDP is a myth?
As a conclusion, I encouraged my friend to really think about what he wants. It is a illusion to demand a maximized, risk-free return which will guaranty a ever-increasing standard of leaving while ensuring his children will get something in 60 years. Goals need to be prioritized and an action plan has to be defined accordingly. In most cases, even apparently conflicting goals can be reached by developing a composite strategy. Nevertheless, any decision will imply that secondary goals
The discussion with my friend started as a “what would you do”, and was pretty animated due to a few cocktails followed by two bottles of full-bodied yet subtle Valpolicella wine in an trattoria in Venice. I won’t be able to transcribe the exact minutes of our discussion, but it was basically turning around usual concepts. The ideal investment should allow to:
• Avoid inflation erosion
• Optimize taxation
• Bear reasonable risk
As I am very risk averse when it come to my own money, the one that I won as a member of the upper working class, I was provoking him in depicting my ideal portfolio: 1/3 real estate (preferably undeveloped), 1/3 bonds or monetary products (CDs, or the like), 1/3 shares and a dash of capital risk. I pushed so far as to pretend I could live with ½ CDs and ½ CR! My friend’s answer to this was:
• CDs and bonds do not exceed inflation after taxation
• Undeveloped real estate is taxed and do not deliver any income
• The financial market (which average is used as a benchmark) delivers the best compromise between risk and reward, which is higher than the monetary market.
• Capital risk is, well… too risky.
All of these are very true indeed. The discussion stopped here. The next few days, I couldn’t stop thinking about our discussion. Something is wrong, both conceptually and heuristically. After a few more drinks, I was able to point it out: the financial market does not deliver higher return than monetary market, and if it does, the premium is ground by inflation. In other word, people are expecting a “sufficient return” by which their financial capital should grow, which is, at any given level of risk, a positive net return rate .
Following this principle, at zero risk, the acceptable return should equal inflation. Nobody will be happy with that. Why? Because our common understanding is that, “on a long term, the market is more profitable yet not really more risky, than bonds”. The very same common understanding defines “the market” as the average of the stocks, as a sort of meta-index. That alone would be interesting to discuss, but I am choosing not to . Instead, I will embrace the common sense assumption that it is indeed possible to consider a market average as the market general performance.
The other component is the taxation rate. Let’s consider a rate of 16% on capital gains . It applies to the gross return. The inflation also apply to the gross return. As a result, the necessary rate to beat both inflation and tax is given by the formula (R=return rate; i=inflation rate; t=tax rate), i.e. 2.4% for a 2% inflation. Tax acts in fact as a multiplier of “acceptable return” expectations. As a conclusion, people are demanding that their capital do not decrease by anything but their own ability to make arbitrages or to simply spend it. Inflation and tax are seen as negative environmental effects which have to be balanced by opposite effect of return on investment.
The negative effect of tax is easy to understand: people think they always pay too much, and they want to consider their NET profit. What about inflation? Does it matters the same way tax does?
To go any further, we need to revisit the definition of inflation and why it matters to people. People would like to have the comforting feeling that their capital keeps the same “value” value according to which benchmark? Are we talking about just purchasing power? If yes, we have to consider the ability of people to accumulate goods. For example, after a while, people won’t need to spend the same amount of money since they will be equipped with a theory of durable goods they won’t need to replace. For example, if I bought a Corvette for $51,000 in 2008, I won’t have to disburse cash in 2009 again to replace it. Therefore, from a cash-disbursement point of view, I will have $51,000 less need in 2009 than in 2009. Therefore, my purchasing power mechanically increases by $51,000 between 2008 and 2009 have. If people really mind about their ability to disburse at least the same amount of cash, they will have to take into account their ability to accumulate goods, making it less urgent to disburse for goods they don’t need any longer. In other words, people should consider that part of the capital they are spending is not actually spent, but converted into non-financial capital. From a purchasing power point of view, this non financial capital increases the apparent purchasing power of their financial capital. Non financial Capital shouldn’t be limited to durable goods: services like plastic surgery, travels and even restaurants, is also to be considered as increasing purchasing power, since it is more likely that people, with time, will diminish their consumption of those services (except Michael Jackson or the Schwarzenegger couple). In other words, from an individual purchasing power point of view, the financial amount necessary to ensure an equal standard of living will increase over time following the price increase of goods and services, but will decrease at the same time by the effect of good accumulation and lassitude to consume.
As understood from above, determining the right amount of return will impose to plan several years ahead in term of cash. Why not just consider the CPI as a composite indicator of what is needed?
Because CPI sucks! CPI is manipulated by very intelligent statisticians to reflect the real price of things. For example, they do not compare the price of computers in 2011 to the price of computers in 2012: they factor into it the effect of technical enhancement and subtract it from the price increase. In 2010, we are talking about a 2.5 lbs 12 GHz, 2.5 TB machine for $159. In 2011, the price of the equivalent machine is $175. Will CPI be 110? No, because the $175 machine is only 2.2lbs, but 3.5TB! so our statisticians will come up with an estimated value of $161 for a 2.5 lbs 12 GHz, 2.5 TB machine in 2011, i.e. a CPI of 101.3! Magic! Using the same principle, it is most likely that the future equivalent of your current 2008 Corvette will have a lesser value in 5 years, due to the technical improvements which will occur. Too bad if you don’t need the forward-anti-collision-radar or the weather-link detection device : both come standard! You’ll have to pay for it, but it won’t be part of the CPI. On the contrary, the product meeting the original specs of your 2008 corvette will probably be a cheap Chinese sport car.
I could multiply the examples forever, but you should have a good understanding of the picture by now: CPI does not reflect people’s purchasing power evolution. Two phenomena generate deformation effects: first, the technical progress (and built-in obsolescence) force people to buy more expensive products incorporating more and more features (that is also called “progress”), but, in essence, productivity gains and other fixed cost amortization are commoditizing the vast majority of goods and services.
The third possibility is to use the monetary definition of inflation: inflation is the increase of money in circulation. And it is not actually all bad, since part of it is covering the GDP growth. So the bad inflation which is the one on top and beyond the GDP growth, is the one which devaluate people’s financial capital. Now, following the capitalist idea that financial market reflects economy (and vice versa and all together, the market is efficient), any money creation above and beyond GDP growth generate bad inflation, decreases people capital, and has to be eradicated. Then, how should we consider a financial market which could generate more return than the GDP growth? Inherently, by definition it’ll generate money without economic counter value. In conclusion, any financial market serving more than the GDP growth is generating inflation, which in turn decreases the net value of the financial capital.
Should I say that we just demonstrated that expecting financial return above GDP is a myth?
As a conclusion, I encouraged my friend to really think about what he wants. It is a illusion to demand a maximized, risk-free return which will guaranty a ever-increasing standard of leaving while ensuring his children will get something in 60 years. Goals need to be prioritized and an action plan has to be defined accordingly. In most cases, even apparently conflicting goals can be reached by developing a composite strategy. Nevertheless, any decision will imply that secondary goals
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