Decreasing ROI with Increasing Networth

by Mr. Cheap

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).

 

Be Sociable, Share!

Want to learn more about RESPs? Buy The Book:

Resp-Book

The RESP Book: The Simple Guide to Registered Education Savings Plans

Everything you need to know about RESPs.

See it on Amazon now

{ 2 comments… read them below or add one }

1

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

2

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

Leave a Comment

Previous post:

Next post: