Needs, Wants and Wishes: Impact on Leisure Time and Financial Independence

wants-vs-needs-25216765 (1)We hope everyone had a wonderful Memorial Day weekend. What a great time to remember the men and women who have served us in the armed forces. And, a perfect time to get together with friends and family for a barbeque or other event. It’s also the weekend of the Indy 500 and a time when most of us “start our engines” thinking about summer and leisure time activities.

Yes, we Americans have a hard time relaxing. When did you last hear someone complain about not having enough to do? Brigid Schulte, author of “Overwhelmed: Work, Love, and Play When No One Has the Time” believes part of it is social status. “The busier you are the more important you seem.” Thus people compete to be harried. Apparently, for some young families, competing with the Joneses now means trying to out-schedule them.

More and more women in the workforce certainly has reduced leisure time. In fact, in dual income households, one-third of women earn more than their husbands. And, while dads help more with family responsibilities these days, they still, according to Ms. Schulte, spend half the time their wife does with the house and kids. Furthermore, for many middle class families, wages have been stagnant for decades which means everyone is working harder and longer to make ends meet.

The noted economist, John Maynard predicted just the opposite for Americans and Europeans almost a century ago. In a 1928 essay entitled “Economic Possibilities for our Grandchildren” he imaged a world in which the standard living would be so improved that no one would “need to worry about making money.”  People would be working 3 hour days and have all that they needed. Well, he was correct about the standard of living increasing. Real per capita income has in fact grown 6 times since then. But, he was wrong about the making money part.

It seems Keynes figured that people would stop working once they had enough to meet their needs. But, human nature didn’t stop Americans at that point. Their wants and wishes became needs and so, instead of quitting early, they would work longer to buy the new “needs.” Of course, many of these discretionary items, including larger houses, second houses, fine dining, worldwide travel, etc. weren’t as readily available in Keynes’s time.

University of Chicago Nobel Prize winner Gary Becker, who recently passed away, was one of the first economists to study the aspects of human behavior. He summed it up this way “Most types of material consumption are strongly habit-forming. After an initial period of excitement, the average consumer grows accustomed to what he has purchased and… rapidly aspires to own the next product in line. Human beings evolved so that they have reference points that adjust upwards as their circumstances improve.”

In short, Americans are different from the rest of the developed world. We consume more and work harder. The average employed American now works 140 more hours per year than the Brits and 300 hours more than the average Frenchman. Furthermore, Europeans have become more skilled in taking time off, while Americans, having become masterful consumers, will continue to work more hours to buy more stuff. Keynes presumed that leisure was preferable to labor. Yet, for many Americans, hard work is the only way. In addition, for many, a career provides most, if not all, of their self-realization. We didn’t and we don’t fit Keynes’s model.

As time marches on and one achieves increasing success (and the “reference points adjust upward”), wishes and wants are often perceived as additional needs. This is the American way. It’s a fundamental reason why the United States is the #1 country in the world.

At the same time, for some, ever expanding consumption impacts their leisure time and their financial future. Working longer hours to pay for all their stuff reduces leisure time. Purchasing additional “needs” reduces their ability to save sufficient funds to provide future financial independence.

It’s a good idea to regularly review your financial and personal goals, including financial independence and leisure time. Before you decide to convert some wants and wishes into “needs”, it’s important to understand the choices you are making may impact your leisure time and ultimate financial independence. As a result, we discuss financial and personal goals with our clients regularly. For us, it’s a key part of DWM’s Total Wealth Management services.

Thomas Piketty’s “Capital in the Twenty-First Century”

piketty-capital-21st-centuryI’d sum it up this way: Interesting data, controversial conclusions. Regardless, it’s not often that a 600+ page economics book tops the NYT Best Seller list. However, Thomas Piketty has the right subject at the right time-inequality. It’s a hot and controversial topic for politicians here and abroad. Subtopics are the excesses of Wall Street, minimum wage, and redistribution of wealth.

There does seem to be a consensus that Piketty’s book does a great job tracking the history and status of inequality. His projections for the future and his proposals to remedy inequality, on the other hand, have delighted the left and infuriated the right.

A French born professor at the Paris School of Economics, Mr. Piketty, along with a few colleagues, have done a remarkable job tracking the concentration of wealth deep into the past. In the U.S. and Britain, he goes back to the early twentieth century. And, all the way back to the eighteenth century for France. He also illustrates the wealth of the idle rich of past generations using characters from Jane Austen’s “Pride and Prejudice” and Honore de Balzac “Pere Goriot.” I thoroughly enjoyed how Professor Piketty was able to blend centuries of tax records and history to produce a comprehensive record of the periods of low and high inequality.

Europe’s Belle Epoque and America’s Gilded Age are examples of high inequality. Unequal ownership of assets, not unequal pay, was the prime driver of income disparities. At that time, 20% of the national income went to the top 1%, another 30% to the next 9% and only 20% to the bottom 50%. Contrast that with the low inequality period from the start of WW I to the end of WW II when 7% of the national income went to the top 1%, 18%, to the next 9%, and 30% to the bottom 50%. Since the 1970’s, both wealth and income gaps have been rising to turn of the century levels. As a result, the top 1% again receive 20% of the U.S. income.

Piketty’s contention is that inequality is here to stay and will continue to grow. For him, it’s all about the rate of growth of capital versus the rate of economic growth. He assumes that wealth (aka capital or net assets) will generally grow at a rate of 4-5% greater than inflation. Wages, he contends, can only grow at a rate equal to inflation plus economic growth. In fact, since 1970, wages for most US workers have barely kept pace with inflation, while top earners’ pay has grown at double-digit annual rates. With economic growth falling and returns on capital expanding, the gap will widen, according to Piketty.

Frankly, no one knows what the future might bring. Professor Piketty seems to be simply extrapolating the last 30 years into the future. There is no hard and fast rule of capitalism that this will occur. And, history shows us that, over time, what goes up, generally comes down.

Then, Mr. Piketty really gets everyone’s juices flowing. He suggests that traditional remedies, such as education spending, worker protections, more progressive taxation, etc. may be helpful at the margins, but that inequality will worsen “no matter what economic policies are.” Hence, he suggests that major changes are needed. He proposes a global wealth tax on capital starting at .1% and increasing to 2% annually. In addition, he suggests a progressive income tax up to 80% on incomes above $500,000. These proposals are likely politically unachievable and are considered confiscatory by many.

Certainly, we Americans support equal opportunity. Redistribution of wealth is another matter. If Mr. Piketty’s objective was to spark conversation on a very important topic, he certainly has accomplished that.

Why You DON’T Want to Load Up on The S&P500

The most popular of all market indices, the S&P500, which is made up of the 500 largest domestic public companies, just hit an all-time record high. It is up around 3.5% Year-To-Date (through May 13, 2014) and also is outperforming most of the other equity investment styles, i.e. mid cap, small cap, international, emerging in that same time period. So what’s not to love about it?!?

Whereas our DWM Core Equity Model currently has about a 35% weighing in large caps, we have received a few questions about why our models don’t have more. Several questions have also arisen about why we have the allocation that we do toward small caps, which have suffered so far this year, down over 3%.

There are a few main reasons which I’d like to explain here:

  1. U.S. large caps stocks alone do not provide appropriate diversification – We constantly are preaching about asset allocation and how by adding multiple asset classes one can bring non-correlation benefits to your overall portfolio, which produces a smoothing effect to the return profile, minimizes the downside, and ultimately leads to better long term results. The same concept applies within an asset class. So the more investment styles within equities – large cap, mid cap, small cap, international, emerging – the better, thus ultimately leading to better long term results.
  1. The biggest factor in investor under-performance is from chasing returns; i.e. buying after a streak of hot performance and selling off after a period of weakness. So don’t get caught up in the “investment style du jour”. Large caps are in vogue right now, but that certainly is not always the case. Take a look at the chart below.

Randomness of Returns

As this chart depicts, in both US and non-US markets, there is little predictability in asset class performance from one year to the next. Studying the annual data in the slide reveals no obvious pattern in returns that can be exploited for excess profits, strengthening the case for broad diversification across many asset classes. Investors who follow a structured, diversified strategy are more likely to capture the returns wherever they happen to occur.

That being said, over the past 50 years, academic research has identified variables that appear to explain differences in average returns among stocks. The variables (or premiums) that have stood up to rigorous testing are considered dimensions of expected returns. One of these dimensions is “size effect”. In 1981, Rolf Banz observed that small company stocks tended to have higher returns than large company stocks, as measured by their market capitalization. The size effect provided a more detailed framework for understanding the dimensions of equity performance. No one is certain why small cap stocks have offered an average return premium over larger cap stocks, but many economists assume that markets rationally discount the price of such securities to reflect higher systematic risk.

The chart below shows that this small stocks size effect premium is actually quite significant, leading to an increased annual return of 3.58% since 1927.

US Size Premium

So what’s not to love about small caps then?!? The small cap premium is great, but one can also see that this size premium is neither consistent nor predictable, as the chart above demonstrates. Another reason why we chose not to load up in any one area but to diversify. Therefore, a minority allocation of 15-25% of your total equity portfolio may be appropriate for small caps.

In conclusion, don’t get caught up in the latest fad and chase short-term outperformance by putting all your marbles in one basket such as the S&P500. Instead, think long-term and diversified. Diversified global investors who maintain a long-term outlook are the ones that are rewarded.