Week 157 - Capitalism is a Two-Trick Pony. Learn Both Tricks.

Situation: Sometimes, people with similar socioeconomic advantages become wealthy while others don’t. Sometimes, politicians like to say “the wealthy” have learned to acquire “unearned income” from compound interest, which is correct. Whether or not the acquisition of that skill constitutes real work is debatable. Compound interest is one of the pillars of capitalism, but it can’t work its considerable magic unless a family or business chooses to divert 10-15% of its disposable income away from consumption and toward long-term investments, specifically those that spin off dividends that grow annually and are reinvested to “compound” the benefit. The other pillar of capitalism is accrual accounting, which is the discipline of paying recurring expenses in real time by identifying and encumbering a specific part of current income. That leaves only non-recurring capital expenditures to be “financed”, which is usually accomplished by selling assets, borrowing money, or issuing stock.

Compound interest builds wealth gradually. For example, the type of stock selection used for constructing the S&P 500 Index has been duplicated back to 1871. Annualized total return over those 143 yrs is 9.0%, most of which (4.7%) represents automatic reinvestment of dividends in the issuing company’s stock. After accounting for inflation, returns fall to 6.8% but the 4.7% representing compound interest remains unchanged, since dividends are paid in real time. Looking at a much shorter period such as the past 19 yrs, returns were also 9.0% but dividend reinvestment only accounted for 2%, whereas, price appreciation accounted for 7.0% (which falls to 4.5% after inflation). The point is that compounding works its magic slowly. (When this year’s dividend is paid on shares that were purchased with last year’s dividend, the effect is immaterial.)

The real impact occurs when you elect to place that stock position in a trust that only allows dividend payouts to begin in the future, for example to help pay college tuition for your grandchildren. That’s the difference between “old wealth” and “new wealth.” The former sees compound interest as its point-of-main-effort, whereas the latter prefers to spend that money on cars and houses. 

For example, if you’re making $50,000 now you’ll be making $206,000 in 30 yrs, assuming a 5% annual pay increase (2.5% for inflation, 2.5% for merit). You’re starting with a disposable income of $30,000, after deducting $20,000 for taxes and benefits. Assuming that you a) invest 10% of your disposable income online each year in dividend-growing stocks that pay an average dividend of 2.5%/yr and b) automatically reinvest dividends, you will capture the benefit of dividends that grow ~10%/yr (see Column H in the Table). In other words, you will have spent $24,100 on stocks over 30 yrs through automatic dividend reinvestment. That’s after spending $199,300 from your salary to buy stocks, for a total of $223,400. If returns on your portfolio average 10%/yr (see Column C in the Table), it will be worth $1,230,000 at the end of 30 yrs. Your 2.5% dividend will amount to $30,750, or 15% of your salary. 

The second tool you need to learn is accrual accounting, which is the accounting system that the Securities and Exchange Commission has mandated for use by corporations in the United States. Like compound interest, its wealth-giving power is hard to grasp. Only one government entity in the United States has adopted it into law, and that is New York City, which did so in 1975 as the only way for the city to escape imminent bankruptcy. Politicians are quick to point out that problems arise with accrual accounting when tax revenues fall off during a recession, since expenditures have to decrease to the same degree. In that event, the government entity has only four choices: 1) impose higher fees for government services; 2) sell or lease fixed assets like a toll bridge or prison for private operation; 3) stop diverting a small part of current income to fund the Reserve (Rainy Day) Fund; 4) lay off employees. You might point out that taxes could simply be raised, but that would have to be approved by voters at a time when many two-earner households are transitioning to one-earner households. Not likely. To summarize our message on accrual accounting, think of it as using debit cards in place of credit cards to pay bills.

Non-recurring capital expenditures are a different matter. Those can be financed by depleting a Rainy Day Fund (see Week 119) or using irregular income like a tax refund. Families that use accrual accounting can also take out a low-interest loan at the local bank, if interest payments on the loan can be met from your monthly income. Why would the bank give you a low-interest loan? Because you have a high credit rating, meaning you don’t use credit card debt.

Lifeboat Stocks (see Week 151) should be the main asset class in your Rainy Day Fund. This week’s Table shows how our current list of 16 Lifeboat Stocks plus 4 reliable growth stocks (MCD, TJX, IBM, BRK-B) has performed relative to several benchmarks. Red highlights denote underperformance relative to our favorite benchmark, the Vanguard Balanced Index Fund (VBINX).

Bottom Line: Maximize your use of compound interest and accrual accounting.  By starting those habits early, dividend payments on your portfolio alone will likely exceed 15% of your salary after 30 yrs, even if you commit to investing only 6% of your salary each year in dividend-growing stocks. This is true whether you’re a wage-earner with one year of college or a salaried employee with an advanced degree. 

Risk Rating: 3

Full Disclosure of current investment activity relative to financial products listed in the Table: I dollar-average into inflation-protected Savings Bonds at treasurydirect.gov, and into DRIPs for JNJ, ABT, IBM, WMT, NEE, KO at computershare.com.

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