How Wealth Is Created

As investors we all expect a return on our investment but first we need to understand how wealth, the source of that return, is created. If no wealth is being created, there will be no return on our investments. (Paul may get rich by robbing Peter but that is a zero-sum game that does not create any new wealth.)

To create wealth you need a growing economy and for an economy to grow, you need the following:

1. Skilled Labor

2. Natural Resources

3. Intellectual Capital (people with creative ideas, leadership abilities etc.)

4. Financial Capital

You bring these four inputs into a “market” economy and wealth is created. As investors, providing the financial capital, you are entitled to your share of that increase in wealth. It’s what we call the “capital market rate of return.”

When the economy is strong and growing, the return for all four of these inputs will be greater, than when the economy is weak. In the U.S., the return on “financial capital” for the past 100 years has averaged around 10% per annum, but as we all know too well, we have periods when the capital market rate of return is much less, or even negative. Since 2000, the capital market rate of return has been close to zero.

I could interpret these recent numbers as a good sign for higher returns in the future, but I am not here to make a forecast. What I am telling you is that, as investors, we need to pay closer attention to the costs of investing. Wall Street cannot survive for very long in a world where the capital market rate of return is close to zero. They expect more and the only way to get it is to take a chunk of everyone else’s share of the increase in wealth. When the capital market rate of return drops significantly, you never see an equivalent drop in fees.

What you do see, is pressure on the Wall Street sales force to sell high cost products, and the fees end up consuming a much larger share of your return. Losing 2 or 3 percent of your capital each year in fees, has an enormous negative impact on your long-term investment gains. Fortunately lower cost alternatives do exist. Using ETFs, index funds, discount brokers etc. will, in my opinion, always be the better option.