A commenter writes:
I think a satisfactory definition of "rich" is people whose money works for them and generates more income for them, such as investment capital, capital gains, equity income stocks, and trust funds immediately come to mind.
This commenter is wrong. I don’t mean to pick on this one commenter, because several other commenters expressed similar ideas, all of them wrong.
This idea is based on a nineteenth century view of capitalism, and represents the world the way that Karl Marx observed it. A similar idea was expressed in a book I once read by Upton Sinclair, in which one character explained to another that when you’re rich, your money works for you so you don’t have to work.
But this view doesn’t describe the modern economy. Today, passive investments are at best a store of wealth and not a means to generate new wealth. People with enough passive investments can safely be called “rich” on the basis of having a lot of money. Based on my definition of “rich” being that you can afford to send two children to an elite private school without worrying too much about the cost, for a person whose only source of money is a lot of passive investments, the kitty would have to be large enough to cover the private school tuition for two without decreasing it by a worrisome amount.
A partner at BIGLAW is rich because he’s pulling in a million dollars a year. If he’s such a spendthrift that he has absolutely no savings when he retires, then he becomes someone who used to be rich but who lost all his money. He wouldn’t be the only member of such a club. Wealth doesn’t guarantee wisdom.
The BIGLAW partner and the passive investor with $50 million who inherited the money from his or her parents are both rich and they both possess a great deal of capital, but they possess different types of capital. The beneficiary of inheritance possesses financial capital, and the BIGLAW partner possesses human capital.
When I talk about human capital, I am thinking about it in a way different than the typical libertarian-leaning economist who often talks of human capital as being synonymous with how much education someone have. According to my definition, human capital is that mysterious thing which enables one person to make a lot more money than another person. Johnny Depp has a lot of human capital, because he is able to make tens of millions of dollars a year just because he’s Johnny Depp. Human capital, unlike financial capital, isn’t something that can be passed from one person to another. Johnny Depp can give me the money he makes from his movies, but he can’t hand over to me his ability to make tens of millions of dollars a year from his labor.
I previously wrote about four types of human capital. Johnny Depp has all four types of capital. His good looks and his acting skills are biological and knowledge capital. But there are many other good looking people who can act and who don’t make that much money from it. Depp also has track record capital and social capital. Moviegoers want to see him because he’s Johnny Depp. Movie studios court him because of his track record of successful movies.
Yes, the world has changed since the days of Karl Marx. There were no movies in the nineteenth century, and therefore no ways to become rich through acting. And there are countless other examples of this trend in other industries. In the nineteenth century, people generally became rich through owning a business. Today, while it still a viable way of becoming rich, people are more likely to become rich through working in law, finance, real estate, as the manager of someone else’s business (such as a CEO), and a few lucky people also become rich in sports and entertainment.
Because of all the value transference going on, the passive investor will probably lose relative wealth even if they are extremely frugal. In the days of Karl Marx, value transference was a simple affair in which value was transferred from workers to the owners of transferable capital. But today there are a bunch of people with human capital transferring value to themselves at all levels of the supply chain, so being a passive investor doesn’t work as effectively as it used to.
I found this guy’s blog post which has a chart showing the declining dividend yield of the Dow Jones index stocks. The dividend yield has a lot of ups and downs, but if you divide the chart in half, the average dividend yield from 1900 to 1955 is dramatically higher than the average dividend yield from 1956 to 2011. I attribute the decline in the dividend yield to increased value transference taking place between the value creation of the corporate employees and the dividend check being sent to the shareholder.