Back to Basics: The Two Kinds of Capital
February 2022
Capital, in its essence, resolves itself into two forms. One form is wealth. The other is money that runs out.
Clients must decide consciously and actively which form they want their capital to take. If they do not, life will decide for them, and they probably won't like that decision.
Advisors, too, must make a threshold decision: which form of capital they wish to serve. (“Both” can be an honorable decision, but only to the extent that it's made consciously.) Let's put that career decision aside for a moment, until we finish discussing capital.
Wealth can simply but very accurately be defined as capital which continues to earn a return greater than the rate at which it is being disbursed. Thus, wealth is capital which continues to compound.
By essentially the same definition—just turned on its head—money that runs out can be defined as capital which is being withdrawn from at a greater rate than it is historically capable of earning in the long run.
In its simplest and most stark form, then: capital that is not growing is dying.
People who make a practice of withdrawing from their capital at a rate significantly below its long-term rate of return find not just that the capital continues to grow, but that their ability to increase withdrawals grows as well, offsetting the relentless increase in their living costs over time. In other words, they are growing their capital not as an end in itself, but so that it can safely withstand larger and larger withdrawals.
Stated another way, the ultimate goal of wealth is neither growth nor income, but growth of income, to which growth of capital is a prerequisite. But even if you're still at a point in your investing lifetime where capital growth is the main goal, and income growth just a collateral benefit, the investment policy implications are the same. To wit: mainstream equities deliver both blessings to a fare-thee-well; bonds don't. (No fixed-income investment does, hence the name.)
There isn't a whole lot of ambiguity here. Whether one's primary goal in any season of life is growth of capital or growth of the ability prudently to withdraw, equities are to be greatly preferred.
From time to time, advisors encounter “clients” who have no desire to create a legacy, the implication being that they don't need to keep their principal growing by taking—in their parlance—“the risk of the stock market.” They eschew wealth, thereby electing the only alternative: money that runs out.
But they posit a proviso: they don't want the money to run out in their lifetimes. In fact, though not conscious of this absurdity, they're asking us to devise an investment policy that ideally causes them to run out of money and heartbeats at the same time.
This requires the advisor to forecast two perfectly unpredictable variables: the investors' dates of death, and the point at which their money will run completely out. Since we can do neither, we decline to accept this assignment.
Instead, we confirm that there's only one thing we may be able to do. And that is to keep our clients' income/withdrawals growing at a premium to their cost of living for the rest of their lives through equity investing. Again, this will of necessity have the collateral effect of causing their capital to continue to accrete. They may dispose of it at their passing in any way they choose. But these are the only terms under which we can rationally take on such “clients.”
This brings us to the issue of how—I might rather say if—we advise people who come to us without enough capital and/or with elevated income needs which render it probable that they will run out of money at some point. Again, there's not much ambiguity here.
For every million dollars they've accumulated, they can probably start withdrawing around $40,000. If they perceive the need to take out (in excess of Social Security) $80,000, then although it may take a while, this probably doesn't end well. (Not that there aren't myriad ways for people approaching retirement to deal with this issue, first and foremost by not retiring. But for purposes of this example, I'm assuming the folks have already run through all those options, and still “need” $80k.)
This raises the career decision we elected to set aside a few moments ago. What do we do when people come to us who are somewhere between probably and certainly going to run completely through their capital within their lifetimes?
Past a certain point in our career development, I'm convinced that this becomes the essential question. Advisors seem always to be perseverating about account minimums—whether and where to set them and how to communicate them. But I never thought that was the line in the sand. To me, it was and remains: are these people starting with enough capital and/or sufficiently modest going-in withdrawal needs that I can probably keep their withdrawals (and thus their capital) on an upward long-term slope?
As the banzai waves of desperate baby boom retirees keep coming, you're going to get to this point in your career, if you aren't already there. There is reason to ask whether you're prepared for it. Most Spartans have long since divided the world into people who will accept our help and people who won't. But this is a very different issue. It divides the world into people we can help and people who, even with the best heart in the world, we can't.
I'm not telling you how to make that decision, much less what to decide. I'm suggesting you begin to frame the issue in those terms, so that you can make the best decision for your better clients, your family, and yourself.