Why The Rich Get Richer, Part 2: The Danger Zone

Just as for any other asset, the marginal utility of money is a decreasing function. But the marginal utility of money inevitably decreases at a slower rate than any other asset because money can be used to purchase all other assets. Compare the marginal utility of gaining money to the marginal utility of gaining carrots. At a certain point, one can have too many carrots, especially since, as perishable goods, carrots cannot even be converted to cash once they go rotten. But money never rots, and can easily be converted into whatever one desires. So the marginal utility of money will only approach zero once one has literally satisfied all desires, including the desire for unconventional things like giving to charity. Nonetheless, there are important conclusions to be drawn from the fact that the marginal utility of money decreases.

To understand the concept of the individual's decreasing marginal utility of money, consider the difference between Person A with $4000 in the bank, with $1000 rent payable due in a week, and Person B with $500 in the bank, and $1000 rent payable due in a week. If Person A suddenly received $600 in income, he would have many choices of what to do with his money, including saving it. If person B received $600, $500 of this would most likely go towards rent, and the remaining $100 would go towards other essential items such as food.

My subjective judgment is at work here, but I am sure that many will agree with me when I say that the opportunity costs of not getting the extra $600 would be greater for Person B than for Person A. There are extra costs for Person B that would be incurred by not receiving the $600: in not making rent, or in the health costs of malnutrition. Also, at very low levels of wealth, the loss of money adversely affects one's ability to make money in the future. For example, if someone loses his front teeth because he can't afford to see a dentist, he will probably make less of a good impression at a job interview. This is a hidden opportunity cost that people with low levels of wealth must face.

This helps to better illustrate the same phenomenon presented in part 1. It is clear to me that the net benefit of making an investment is not a linear function in relation to one's level of wealth. This is because there are extra costs that naturally arise when one's wealth is at a certain low level. There are unavoidable items, such as basic food, shelter, clothing that everyone must obtain to survive, live with some dignity, and be able to produce wealth in the future. Then there are avoidable items, like MP3 players, which are biologically of a second priority, and do not affect someone's ability to produce wealth in the future. At a certain level, one's wealth will be used exclusively for unavoidable items. (Though people suffering from addiction and mental illnesses may avoid these items in favor of others.) It is apparent that the cost of being without food for a week would be greater than the cost of being without an MP3 player.

All types of investments can be a problem for people at lower wealth levels. As we have seen, if one accepts that the marginal benefit of having money is a decreasing function, one must accept that those with lower wealth will face greater marginal costs involved in any given investment. The marginal benefits of investments will also be greater at low wealth levels, but in smaller proportion than the costs. For everyone, there lies an economic danger zone, at the point where basic needs cannot be sufficiently satisfied by one's funds. All wealth from $0 rising up to the edge of this danger zone must be in a liquid form to satisfy current essential needs. Even risk free opportunities for profit would not be taken by rational people who simply cannot afford them because of the need to maintain a certain balance of liquid wealth. To escape the perils of the danger zone, and make profitable investments, such as those in vocational training, or a new car to help a job-search, one may resort to borrowing, but clearly there are extra marginal costs involved with this, e.g. interest due. Those with sufficient wealth can better avoid borrowing.

Those with enough money to avoid the danger zone are free to take greater risks and reap rewards for doing so. Thus, the rich get richer.

Investors or Inventors

There was an infomercial on T.V. the other day selling a groundbreaking system of stock market analysis, that when put into practice, would guarantee great returns; "We'll teach you how to get in when the stocks are low, and get out when they're high" etc. This was obviously a ridiculous scam. But it may be successful in drawing in victims. The stock market tantalizes people with the possibility of free money. But free money does not, and will never exist. All money gained from investments, (outside of that which arises from pure luck), comes from one of two sources, and both involve hard work:

1. Hard work by an investor in finding profitable investments.

2. Hard work by the invested-in company in gaining profit through its operations.

Nonetheless, in the American mind lies the fantasy of being able to sit at a computer and generate cash with the click of a mouse. People hope that somewhere there lies a perfect investment strategy. But the search for such a strategy is the modern equivalent of alchemy, and just like alchemy, it is a waste of time.

There can never be a fail-safe strategy of investing, because, no matter how sophisticated one's analysis of the stock market is, stock prices depend on an infinite number of unknown events that occur in the actual physical world. Only a piece of omniscient software could predict the future. Secondly, if a trader got his/her hands on this omniscient software, it would become useless if other traders had it too. The best that investors can settle for is to be sensible and manage their risk as much as possible.

Investment strategies are merely ways of siphoning money from the physical or intellectual assets of an economy. And if the productive capabilities of assets in an economy are impaired, it will become harder to make money as an investor. This is a law of financial physics. Even successful short selling depends on an initial price that reflects a perception of high productive capabilities. Securities' prices are merely shadows of the real economy.

Investment is the lifeblood of the economy, but careers as investment professionals are not what I hope the majority of kids of the next generation will strive to attain. I hope they will want to become inventors, not investors. (By inventor I mean someone who creates something new that is valuable to society). How useless would investors be if there were no inventors? There would be nothing to invest in. Inventors also need investors, to fund their endeavors. But good ideas will tend to attract investment. It does not take a degree in Finance to recognize a good idea. I hope the intelligence and creativity of the next generation, instead of going towards the alchemical quest of beating the stock market through technical analysis, will go towards innovations in the actual physical world. Imagine if the world's great geniuses decided to become stock traders instead of chemists, surgeons, authors, engineers etc. These geniuses might think of some great trading strategies, but there would be a lot fewer assets to invest in.

Pure speculation on the rising and falling of stock prices is a zero sum game. But sensible investment in good ideas benefits investors, inventors, and the economy as a whole.