There are some interesting contradictions in the world of financial independence. Though so many of us are evangelists for this approach to life, eagerly spreading the word, there’s a pretty massive body of evidence telling us that, in fact, if everyone wanted to do what we’re all doing, it wouldn’t work for any of us. In other words:
The current construction of financial independence and early retirement only works when most people don’t do it.
Consider those drastic sale prices that frugal folks love to take advantage of, like when brand name cereal goes on sale for $1, or that big screen TV goes on sale for $100 on Black Friday. Stores call those loss leaders, and offer them (at an actual loss, oftentimes) with the understanding that they will lure shoppers in and those shoppers will in turn spend money on high-margin items. Those of us who only buy the loss leaders are essentially capitalizing on the loophole, but if everyone did what we did, stores wouldn’t be able to afford to undercut themselves like that and the loss leaders would disappear.
Consider the Index Fund
Or let’s talk about the darling of so many FIers, the passively managed index fund. The idea of the index fund is simple — don’t try to pick winners, just buy a slice of the entire stock market — but for index funds to work as intended, we need lots of people not indexing, so that the prices of shares actually bear some relationship to reality.
Mr. ONL and I are dedicated index investors, but we know there are a lot of potential problems with them, and that those problems only become magnified the more people invest in index funds. For example:
- Being included in an index is known to boost a company’s share price on average 10 percent, but often more, even if the fundamentals like price-to-earnings ratio don’t support that valuation. According to the New York Times:
Most disturbing is the increasingly distorted levls of the valuations of some of the largest index funds. The combination of a long-toothed bull market and the significant shift to passive investing has indiscriminantly buoyed all stocks in major indexes like the S&P 500 and Russell 2000. Stocks that might not be bought singly on their own merits have been lifted by the package buying. Some portfolio managers, academics and market trackers now contend that the soaring of the mediocre alongside the exceptional has produced unusually elevated valuations.
- The New Yorker makes a very similar argument, adding that index funds run the risk of persistently and frequently creating bubbles:
It’s not hard to imagine large-scale passive investments warping the stock market in similar ways. Typically, stocks are indexed by market capitalization—the value of a firm’s share price times the number of shares—from highest to lowest. A market with more passive investors than active ones will continue to push money into the largest firms, whether these companies are actually performing strongly or not. Timothy O’Neill, the global co-head of Goldman Sachs’ investment-management division, told me that essentially every new indexed dollar goes to the same places as previous dollars did. This “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision,” he said. O’Neill fears that the result will be a “bubble machine”—a winner-take-all system that inflates already large companies, blind to whether they’re actually selling more widgets or generating bigger profits. Such effects already exist today, of course, but the market is able to rely on active investors to counteract them. The fewer active investors there are, however, the harder counteraction will be.
- And, very smart people like Charlie Munger think the rise of indexing undercuts corporate governance, creates permanent owners who will never sincerely threaten to sell, and [my words, not his] could allow CEOs and boards to make decisions with little regard for the shareholders. A piece in Forbes makes a similar point:
“We are now in a situation where index investors are the major shareholders in most of the large- and medium-sized public companies in the United States,” says Luis M. Viceira, the George E. Bates Professor and senior associate dean for International Development at Harvard Business School. “That raises the question, who is exercising control in these corporations?”
In other words, the more people who index, the less shareholder oversight and corporate governance pressure there is, the less accountability there is, the more likely bubbles will be, and the less share price will have to do with underlying essentials. Fun!
So let’s say it all together: Indexing only works if we don’t all do it!
(Bummer, I know.)
But let’s take a big step back away from index investing, and talk about investing for early retirement as a whole. If everyone did what we’re all doing, would it still work? Let’s discuss!
The entire FI community is built around the idea of the shared secret: We know something most people don’t.
And though here I am, writing on the internet about early retirement, I’m definitely in the camp of wondering how far this idea can spread before it starts to fall down. In other words, like with index funds, is there a point at which it no longer works if too many people are doing it?
Spoiler alert: I think the answer is yes.
Just as we can’t all travel hack our way to fabulous vacations and expect credit card companies, airlines and hotel chains to keep offering those bonuses (they are hoping you start traveling with them often, and paying cash money for it, so that the deal is actually profitable for them), and we can’t all buy only the loss leaders and expect stores to stay in business, I think we can’t all follow the current construction of the FI life and have it continue to be tenable.
Here’s my case. Let me know in the comments if you agree.
The Idea Behind Stock/Equity Investing
You already know this, but the entire idea behind investing in shares of something is that you see value in that thing, and you want to purchase a slice of that value, either because you think its value will increase over time, or because it pays an attractive level of dividends, and you want in on that.
Though stock investing has become this mystical-seeming thing to many investors because the people who keep track of all the details — CAPE ratios, profit-to-loss statements, growth plans, capital owned, overseas projections, etc., etc. — act as gatekeepers, it’s a very good thing that those people are keeping tabs on companies’ numbers. Because without that scrutiny, share prices could quickly become divorced from actual value.
All of those factors are important in many ways, but fundamentally as a long-term investor, you’re asking a simple question: Does this company make money, and is it likely to keep making that money or make even more in the future?
If the answer is yes, assuming the details line up, it’s probably a safe investment. If not, run away. Simple, right?
How Companies Make Money
Here’s another thing you already know. Virtually every company out there makes money one way, and one way only: when people buy things.
Those “people” might be individual consumers, they might be small businesses, they might be megacorps or governments or private institutions. But profit happens when goods and services are exchanged for currency.
Which means: For a stock to look attractive, it needs to be equity in a company that’s making money or expected to make money, which means lots of people are buying what it’s selling.
Market Valuations When Everyone Wants to Retire Early
The potential bubble problem with index funds is a case of being a victim of your own success. The idea behind indexing makes total sense, but its fundamental flaw is that it relies on most people not doing it. (And even with that flaw, we’re not changing our approach anytime soon. We can’t quit you, Vanguard.)
The same is true of the conventional early retirement wisdom. Which isn’t to say that early retirement wouldn’t work at all if everyone did it, but we’d have to figure out a very different way to make it work. (And no, not everyone could switch to real estate investing. If everyone’s a landlord, who do you rent to?)
But as we as a community tend to talk about financial independence these days, it tends to follow a pretty simple formula:
Buy less stuff + Invest that money instead
= Financial independence
Again, simple. But let’s break it down.
The Law of Supply and Demand — and Early Retirement
Consider if everyone followed this formula, buying less and investing more. We’d suddenly have much lower demand for consumer goods, but paradoxically, more demand for stock in the companies selling (now unsuccessfully) those consumer goods. In fact, demand for equities would quickly outstrip supply, and prices would jump and keep jumping as people get better at saving instead of spending.
Meaning: share prices would skyrocket, even as corporate profits start tanking.
The fundamental problem is we’d create a different kind of bubble, one in which share prices would become totally divorced from earnings, profits, and even the value of assets owned by publicly traded companies. Share prices would be based entirely on demand, not on the value (supply) provided by the stock.
A pretty messed up way to apply the law of supply and demand.
Betting on GDP (If We Still Have Jobs)
Charlie Munger and others who are concerned about indexing creating too little corporate oversight, but if everyone jumped on the FI bandwagon, I don’t think that would be our problem. What the corporations themselves do would be fairly irrelevant, except for a few that represent things we can’t avoid spending on, like food and energy. Instead, stocks would become true bets, more like actual gambling and less like equity investing, and index investing would become essentially betting on the growth of gross domestic product (GDP).
In other words, equity investing in a world in which everyone wants to retire early would be a bet writ large on the entire economy.
That is, assuming anyone still had a job. Because if companies aren’t selling stuff, how do they afford to employ people? We’d see a huge shrinkage of employment, outside of those unavoidable purchase categories, meaning it’s an open question how much people would have to invest in the first place, and how much those share prices would actually climb.
So What Should We All Do Instead?
Though I think there are some huge systemic barriers that make early retirement a total fantasy for a lot of people, I’m not interested in hoarding this secret for the lucky few of us who know about it now, and pulling up the ladder behind us. I think about how much we’ve gained just in the journey of pursuing FI, and how much that has improved our lives and outlook on the world. That’s something we want more people to experience.
And I’m also not interested in telling everyone that they should continue to be mindless consumers and to buy all the things so that we can keep this early retirement dream alive for a privileged few of us. As an environmentalist, you know I’m not about continuing to make more disposable stuff (or quality stuff to “declutter” one day, which usually means throw into the landfill, even if you donate it intending it to be repurposed).
So what’s a different way to make this work for more people?
Mr. Money Mustache sort of tackled this question several years ago. I say sort of because in the set up, he shoots down critiques of the notion of everyone being able to retire early, but then he doesn’t really address that. He only talks about what happens if everyone becomes frugal, not if everyone starts enacting the high savings rate and aggressive investing vision with an eye toward not working. His answer relies on people continuing to work, albeit in ways that are more beneficial to the planet and humankind (which I fully support, if you’re into working for a living).
I think making financial independence closer to universal could look a few different ways:
- Most people could keep working in some small amount, far less than full time, but enough to provide for their basics and to cover a few creature comforts that also keep stocks afloat.
- We could be less reliant on stock returns to provide for us in early retirement, save more than we otherwise would, and settle into a far simpler existence without the perks like hacked travel or increased spending power from bull market portfolio growth.
- We could adopt universal basic income, which would cover everyone’s basic needs, allow those who wish to do more work to do so, but give more people the freedom to invest their time in meaningful work like volunteering, parenting, taking care of family and friends, and other projects that benefit society.
Of course, all of that said, we’re nowhere near a situation in which even a sizeable minority of people are ready to save a hefty portion of their income, so this “problem” is currently completely imaginary. But it’s always interesting to follow an idea to its logical conclusion. Or, at the very least, to remind ourselves how lucky we all are to have found this secret loophole, and to be grateful that we found it while it still exists!
You Must Have Thoughts!
Alright guys, it’s your turn. Lay it all on us. Agree with anything here? Vehemently disagree? See some flaw in my logic you wish to point out? Have an alternate economic theory that you think applies better? This post is here purely for discussion, so let’s dig in!