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How to use equity premium to invest like a billionaire

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By John Beveridge - 
Equity premium invest like a billionaire how to

Equity premium refers to the excess return generated by shares above the “risk free” rate available through investments such as bonds.

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One of the great wonders of the investment world is the power of the equity premium.

In simple terms, it refers to the excess return generated by shares above the “safe” or “risk free” rate available through investments such as bonds.

There are all sorts of arguments about how or why the equity premium is generated but the only thing the investor really needs to know is that historically, shares have provided a return higher than you could get by investing in bonds – at times a very much greater return.

The price that investors must pay to access this premium is volatility, which is a lack of certainty about the price of a share investment at any particular time.

Living with volatility brings big rewards

That means there are good and bad times to buy and sell shares, so the investment horizon needs to reflect that.

Volatility can be tough to deal with in particular time frames but if you pan back far enough to see a longer time frame, the equity premium more than pays for the lack of certainty presented by the bumpy general run up in share prices.

When you combine the equity premium with the power of compounding you have a seriously potent wealth generation engine.

Billionaires invest differently

All of this sounds fairly theoretical until you look at some excellent research produced by Goldman Sachs using US Federal Reserve figures to compare the difference between how the top 1% of wealthy Americans invest compared to the bottom 50%.

The figures would probably be a little different in Australia, but similar enough to make the point.

What the research found was that the top 1% – effectively billionaires and almost billionaires – had a dramatically different asset allocation compared to the “average” American.

An amazing 61% of billionaire wealth is in shares

The average amount the top 1% had invested in shares was a staggering 61% – concrete evidence that the very wealthy have used, and continue to use, the equity premium and the power of compounding returns over time to grow and maintain their wealth.

It only makes sense when you consider that someone like Elon Musk has the vast bulk of his wealth tied up in shares in his companies – a situation common to many billionaires.

Poorer households buy property

What about the bottom 50%?

Well, for the poorer households, just 4% was tied up in shares, keeping exposure to the equity premium at a very low level.

By contrast, the bottom 50% had the majority of their wealth – 55% – tied up in real estate.

That probably makes sense in some ways for poorer households who are trying to keep a roof over their heads as a basic building block for their wealth.

This is also not to say that real estate is a worse investment than shares – on some 10-year comparisons in Australia it has outperformed shares – but for the purposes of investment here there are plenty of problems with it.

Most real estate owned by the bottom 50% would be subject to loans so it actually costs money to keep and even if that makes financial sense compared to renting, in cash flow terms it is performing more like a liability than an asset.

Property is also hit by a raft of taxes and costs from stamp duty and rates to maintenance and land tax.

Shares have some inbuilt advantages

Shares have the advantage of cheap and easy purchase and sale, a higher yield, transparent pricing and little in the way of ongoing costs.

This analysis might seem unfair to the poorer households and to some extent it is – clearly, they don’t have the surplus capital to commit to investment and if they aren’t buying a house, they will still need to pay rent.

However, even allowing for that, the way the ultra-wealthy invest is a clear sign that what they are doing works well to build wealth and with their real estate holdings just 11%, the challenge is clear.

Increasing the share allocation can generate big returns

If the poorer 50% could up their shares component from 4% to 8% that would make a dramatic difference to the eventual outcome, particularly if they continued to increase that percentage as circumstances allowed.

Potentially, they could also use superannuation to multiply the power of the equity premium in a low tax environment.

Remember, we are talking about asset allocations here, not raw dollars, so it is possible to change these percentages as long as they don’t eat into spending that is absolutely essential for living.

Compounding a 9.4% return quickly multiplies capital

With the average return on Australian shares (capital plus dividends) coming in at 9.4% a year, over time that can compound to be many times what the compounded risk-free return would be and can fairly quickly double and triple the original capital invested.

Accessing that equity premium is also easier than ever given the broad diversification available through exchange traded funds (ETFs) and listed investment companies (LIC’s) and the ready access to offshore markets.

The lesson is clear – the higher the percentage of shares in your asset allocation, the wealthier you will become over time.

After all, a few hundred billionaires can’t all be wrong.