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Abu Dhabi, UAEWednesday 26 September 2018

Economics 101: Stop trying to get rich quickly from investments

Asset bubbles experiences have delivered a consistent lesson to prospective investors: stop trying to get rich quickly

An Ethereum coin representation. Crypto currencies are having a torrid time. Bloomberg
An Ethereum coin representation. Crypto currencies are having a torrid time. Bloomberg

As the Bitcoin rollercoaster continues its wild swings, you may be tempted to think that the opportunities to get rich quickly from investing in the cryptocurrency are unprecedented.

In fact, asset bubbles have been common throughout the entirety of human history. One of the recently popular versions in the Arabian Gulf is buying real estate in an emerging economy, such as houses or condominiums. However, these experiences have delivered a consistent lesson to prospective investors: stop trying to get rich quickly. Why is that the case?

Before I explain, it’s worth pointing out why people continually strive to earn life-changing returns in short spaces of time, with minimal effort. While gamblers will, on average, lose money, there will always be a small percentage who win big, just like the winners in a lottery. Today, in the age of social media, these people will get high exposure, and they will act as living proof of the ability to get rich quickly.

The attractiveness of the gambling/investing route to rapid wealth accumulation is accentuated by the unattractiveness of the alternative way of becoming very rich, which is becoming a successful entrepreneur. Self-made millionaires invariably have to work extremely long hours, suffer severe stress, and expose themselves to high levels of risk. Almost nobody is willing to tolerate such conditions, except for the super-driven, meaning that ordinary people have a choice between normal wages, or a get-rich-quick scheme, including buying into an asset at the “right” time. There is always the option of marrying into wealth, but for most, that’s even less likely than winning the lottery.

So why are stock markets and their ilk poor routes to quick riches? To see why, we first have to understand the actual purpose of financial markets. People - most frequently high net-worth individuals and institutional investors - trade financial assets for two reasons.

First, as a way of managing risk. Bill Gates is super rich from the Microsoft shares that he owns, but if Microsoft crashes, so too will his portfolio. Therefore, it makes sense for him to sell Microsoft shares to, say, Elon Musk, for instance, who in turn sells Tesla shares to Bill Gates. Both are still rich, but the trade has diminished the level of risk that each faces.

Second, as a way of learning about assets’ underlying values. By trading shares, for example, and seeing how willing people are to buy and sell them at various prices, I gradually acquire information about their likely long-term value. Most markets involve useful information distributed across many traders, and the execution of trades is the only way to forcibly tease that information out so that others can benefit from it. Just think of how you behave in a jewellery market: you ask about prices, you watch others haggling, and you inspect the merchandise, before ultimately deciding what you want to buy.

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Aside from these two functions, the results of asset trades are basically zero sum, meaning that if I make lots of money, someone has to be losing lots of money. Equivalently, it is impossible for everyone to get rich quickly. Financial markets do not create wealth out of nothing; they exist to help people diversify their portfolios and to learn about new assets.

OK - so how do you make sure that you are one of the ones that makes lots of money quickly, rather than one of the ones that loses lots of money? Unfortunately, unless you are willing to break the law by committing insider trading, or by defrauding people, then there is no way to make sure that you are one of the get-rich-quick minority. You have to be “lucky”, which, by definition, is not something you can systematically work toward.

But what about your friend who brought that condominium that has now tripled in value, or the one who purchased Bitcoin at the start of 2016, and is now a millionaire? Well, for the most part, they were just plain lucky. Alternatively, you are only hearing about their successful investments, and haven’t heard about the ones that tanked and are now worthless, just like your friend on Instagram who posts pictures of all the nice meals that they prepare, while refraining from sharing pictures of the failures.

Unfortunately, it’s not enough to be lucky in asset prices; you also have to be lucky to avoid being conned. Many people’s livelihood depends upon tricking unsuspecting non-specialist investors into parting with their life savings in the pursuit of quick returns. That’s one of the reasons that Facebook recently banned Bitcoin advertisements.

How do you avoid being conned? The most important step is acknowledging that getting rich quickly is not a realistic option for normal people. When you see a genuine financial consultant, rather than a conman, their opening speech will probably be about how to plan to make a safe investment for the future, corresponding to an annual rate of return of around 5 per cent. This isn’t because they lack knowledge or marketing nous - it’s because they are telling you the truth, no matter how unsatisfying.

Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain.

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