Photo Credit (CC 2.0 license): Eric Golub
A lot of investors approach wealth building as if it were a vending machine. They expect to regularly invest a certain amount of money each month and then sit back and watch it grow at around 10% a year.
After all, this is how investing works, right? You put your money into the investment vending machine and come back in 30 or 40 years to find that it has spewed out millions and millions of dollars for your retirement.
Unfortunately, this is a diabolical lie. Wealth building is nothing like a vending machine at all. The universe is simply under no obligation to give you a 10% return on your money in perpetuity. Real wealth building just doesn't work that way.
Let me tell you a story that encapsulates this misguided vending machine analogy perfectly. I recently stumbled across a post by the financial blogger Joshua Kennon titled "Diamonds Are A Perfect Example of the Inability to Calculate Financial Intrinsic Value".
In the post Joshua relates how he had visited Borsheims - a Berkshire Hathaway owned jewelry store. I'll allow him to tell you the rest of his story below:
…there was a wedding band that caught my eye. It was phenomenal. It featured 5.34 carats of diamonds in a platinum eternity setting, with the diamonds rated in the exceptional white colorless range (F on the GIA scale) and a VVS in clarity.
I ran the compounding math in my head. Ten or twelve times. If I were to buy two identical copies, even at the Berkshire Hathaway discount price (which the sales associate was kind enough to ballpark for me and is substantial - at minimum 30% off retail, probably more) at an average rate of compounding, by the time I was Warren Buffett’s age, it would cost me $5 to $10 million in foregone wealth. That is my opportunity cost.
So I went ahead and ran the numbers on this guy's "opportunity cost". He states that one of these eternity rings would cost $27,000 at retail. At the 30% discount he references, two rings would cost $37,500. The "about" section of his website says that he is 35. Therefore I estimated that the difference between his age and Warren Buffet's is around 50 years.
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By dumping all of this information into a spreadsheet and working a little finance magic I can infer that Joshua thinks he will garner an average return on his portfolio of 10.26% to 11.80% annually over the next half a century.
That belief is, in my humble opinion, utterly insane.
It completely ignores financial history, where wealth building via compound interest has regularly been wiped out by global wars, ugly debt defaults, bloody revolutions, horrific stock market crashes and messy nationalizations.
Like it or not, the diamond eternity band that caught Joshua's eye will undoubtedly still be around (and worth a substantial amount of money) in a couple centuries. In contrast, it takes a certain naivety to trust that Berkshire Hathaway (or most of today's other major corporations) will still exist in the year 2200.
Now I want to make it clear that I don't think buying diamond eternity bands from Borsheims (or any other jeweler for that matter) is a good investment. White diamonds are my least favorite gemstone from an investment perspective (with the notable exception of old cut diamonds). Anyone looking for the real sleeper hit of the gemstone world should bypass white diamonds entirely and check out spinels instead.
In addition, paying a jeweler's retail price (even a "discounted" retail price) is almost always a poor move. The fact is that most new jewelry instantly depreciates by 75% to 90% the moment you walk out of the store with it. This is why anyone interesting in using jewelry as an investment vehicle should 1) do a lot of research before they buy and 2) always buy antique, vintage or estate jewelry on the secondary market.
But I digress.
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Compound interest can work wonders for your portfolio, but there is a paradox buried in this conventional wealth building strategy. If you happen to invest in a time of peace and prosperity, you can be rewarded with seemingly ever increasing paper asset prices. This situation can endure for many decades at a time - so long, in fact, that it is easy to become complacent (and start implicitly believing in the investment vending machine theory).
But the good times inevitably lead to an over-issuance of paper assets like stocks and bonds. The physical economy simply doesn't grow fast enough to support all the new paper claims against it. The only solution is ultimately default - either through inflation or bankruptcy. In both of these circumstances, holders of paper assets suffer terribly while investors in hard assets - antiques, precious metals and, yes, gemstones - benefit tremendously.
The last time the developed world experienced a synchronized restructuring of financial assets was the 1930s and 1940s. During this time, massive numbers of bonds, stocks and even currencies became effectively worthless, leaving many ill-prepared investors destitute.
But that was a long time ago - over 70 years now. As a result, today's investors have forgotten the paradox of wealth building: compound interest is so powerful that no economy can sustain it forever.
Unfortunately, we seem to be right on the cusp of financial history at the moment. It is apparent that our bloated financial system won't be able to stagger along much longer under the weight of its excessive paper asset obligations. The smart money knows that tangible assets are the right wealth building strategy for the coming financial implosion, and now you know it too.
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