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David and Tom Gardner

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from: David Gardner

Learning Not to Pay the Piper

Posted Tuesday, May 8, 2001, at 2:00 PM ET

Tom,

I only have time at this moment to answer your first question, which is much more grandiose than your second, anyway. It's a great question. You asked:

Question 1: What do you think is the single most convincing piece of evidence that Americans don't fully understand the power of compounding when it is applied to their money?

Good. But I must first investigate the phrase "fully understand the power of compounding." You see, many people who may "fully understand" something on a rational level nevertheless will fail to align their own actions perfectly with that rational understanding. So, given this, would we still say they "fully understand"?

No exercise in pedantry, this. Simply a necessity before providing a proper answer. You see, many people might be convinced by straight logic that they should invest their money with the power of compounded returns, keeping it stuffed in the turkey for five decades. However, when it comes to the actual doing of it, in the 12th year they suddenly grow fearful about the stock market, or they get tempted to dip into that pool of funds for some shorter-term satisfaction (not always a sin, either) and wind up undermining--or flat-out cutting off--the power of compounding in their lives. Did they "fully understand"... in the "fullest" sense? Debatable.

But I'm going to assume, since you modified "understand" with "fully," that you intend this full understanding to carry fully all the way through from thought to action. And given that, my answer (ta dah!) would be:

Answer: Whichever is greater: 1) The amount of tax receipts that come in every year via both capital gains and income from dividends and interest or 2) the amount of retirement plan money presently sitting in low-income-earning vehicles that is intended to be invested for five years or more.

Again, whichever dollar figure computes to a higher total is the more damning statistic.

Speaking to the first, in our society every time we cash in a winning investment we pay the Piper. And of course the Piper pipes happily alongside the amounts we receive via interest and dividends each year, as well. Once you fully understand (there's that phrase, again) the detrimental effects of these self-administered taxes on your long-term financial prospects, you will generally seek to reduce their effects wherever possible. For many people that means two profound changes. The first is trading less, tending to show more patience and, importantly, to invest in growth stocks that will show significant gains measured in decades rather than days. The second is tending to avoid investments that pay out annual taxable dividend and interest income. By following both of these prescriptions, one winds up paying much less to the Piper year in and year out and consequently has much, much, much more as the decades pass. So I think if you took all the short-term capital gains, as a start--which are taxed at our income tax rate--and mix in the money paid in long-term capital gains (1-plus years) that ideally should have been held for years more, then mix in some of the tax monies paid in interest and dividend income tax that should instead have been invested in a low-taxed/high-growth vehicle like an index fund, you'd have a whopping big sum that would answer your question.

But does it out-whop the amount of long-term investments sitting in our nation's IRA and 401(k) plans in the equivalent of money-market funds?! Those dollars are being socked away by people intending them to grow over decades. Yet mostly through ignorance they don't realize the opportunity cost they're paying by not being in an index fund (or at least a growth fund).

If that total is higher, it's probably an even better answer to your question.

Did I pass?

Mahalo Fuyeka to you, my brother.

David

the breakfast table
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from: David Gardner

Learning Not to Pay the Piper

Posted Tuesday, May 8, 2001, at 2:00 PM ET
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David and Tom Gardner are co-founders of The Motley Fool, a personal finance company. They are dedicated to educating, amusing, and enriching people through their Web site, books, newspaper column, and radio and television shows.
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[Notes from the Fray Editor: We're running Arthur Stock, because of his starring role in this week's "Breakfast Table" (this was his featured post), but Kate persuasively argues the opposite about Krispy Kreme here ("Hot sugar and fat beat microchips..."). Some good ruminations about the quality of life of the have-nots: try LT here (the lifeguard was a woman in fact--LT knows why that would be ironic...), or this post: "Short sightedness does not magically transform the HaveNots into Haves, it just keeps them from griping about the inequities." RonK has a comprehensive flame post for anyone looking for an argument here. There are Questions for Sowell here from Tom R, and two points of view on what The Fray has to offer in this thread.]


Krispy Kreme is a pure momentum play, and its momentum is played out. It's a product that appeals to the stock-buying class, and was new to many in that class (since it went national very recently) when they bought the stock. These stocks do well at first because people buy the stock after enjoying the product, without looking at balance sheets. Then the stocks collapse to sane levels--P/E closer to 20 than 90. Think of Calloway Golf Clubs some years back, mircobreweries, cigar sellers, Yahoo, and in the food world Snapple and Boston Chicken. Starbucks is almost an exception that proves the rule, but even it had several 50% falls along the way.

Krispy Kreme has limitations that can't be fixed: food is a competitive industry; Dunkin' Donuts demonstrates that there is competition even in the sub-category; franchise operations are subject to all kinds of accounting gimmicks for the first year. Boston Chicken, now in bankruptcy, was notorious--I don't know if Krispy Kreme is playing accounting games, but it would be difficult to determine that it isn't.

Foods with holes in them are especially poor investments, as Manhattan Bagel, Einstein Bagel, and several other bagel purveyors proved.

--Arthur Stock

(To reply, click here.)


 Whenever I hear someone start talking about finding for-profit solutions to social problems [Monday's entry] I think of a quote by Bill Speidel about Seattle's city fathers. "If they could have made more money by not building a city, they would have."

And there, in a sentence, you have the promise--and the problem--of for-profit ventures. What looks from outside like a remarkable feat of a healthy social conscience, in truth, relies on nothing more than a healthy respect for the bottom line.

The trouble is there in that "if" clause: when that bottom line comes into conflict with the social goals and one or the other has to give, which way are the venture philanthropists going to jump? Especially with any philanthropy that ventures into the tricky area of public goods, the good accomplished is only rarely monetizable.

--James Grimmelmann

(To reply, click here.)


 As far as I know, no society has yet come up with an incentive structure which rewards leaders by how well they are able to make impartial policy decisions, though it would be a great discovery. It's a nice try, but I don't think hiring economists to run the country would be the perfect solution.

The problem with economists is that they study only certain social relations, those that can be converted into cash. There are indeed harsh economic realities that we must face in making policy decisions. However, there are also harsh social, diplomatic, and environmental realities which economists do not take into account in their analyses. Of course economic growth is important, and policy makers should know exactly what they are doing to the economy and to individual businesses, but they should not assume that commerce trumps all other interests. (Stop waving those copies of Atlas Shrugged at me! Ayn Rand isn't even an economist!)

--Jane Grey

(To reply, click here.)

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