In a previous post I used Mitt Romney’s 2010 tax return to draw your attention to how different tax rates apply to different income types, specifically capital and earned income. In this post I want to focus on capital itself and how it’s used to make money. Capital’s just a tool like the lever and fulcrum above. Like it a small amount of force (capital) when used effectively can lift a heavy load (make a lot of money). Romney’s tax returns demonstrate that he was a creative master with the ‘capital’ tool, a regular Michelangelo.
For our purposes, capital’s simply money that’s been saved and is now available for productive use. Romney’s job when he headed up Bain Capital (a private equity firm) was to put capital to its highest and best use for Bain and it’s investors. That meant simply finding businesses where capital would have the greatest impact make the biggest difference. In order to compare those investment opportunities they used various measuring sticks one of which was undoubtedly return on capital. I say undoubtedly because Bain like any other enterprise has to compete for capital from investors and as such return on capital is the relevant measuring stick. 2012 examples of annual return: a savings account has a return of capital of less than 1%, United States 10 Year Treasuries less than 2%, the broad stock market 7%. Private equity’s mission is to return greater than 25% per annum over time.
You should understand with big returns comes big risks so by definition private equity investors are big risk takers. Taking big risks, however, doesn’t mean they’re just rolling the dice, it means they have enough capital to seek out high reward opportunities having full knowledge they could lose it all. Private equity investors seek out managers like Romney and Bain who they believe are honest, hard-working and savvy. Choosing which businesses to make investments into requires extensive human capital and skill. So it’s really a brain game, capital’s just a tool.
What’s this have to do financial literacy?
In order to reach our financial goals we need to quantify those goals, save some of our cash flow and invest it to reach them. As part of the quantification there’s a concept called required return. That’s the average annual return needed based on savings available. If the required return relative to market returns is high you’re risk in reaching those goals is high. If that’s the case you need to figure out how to make it work. It too, personal financial planning, is a brain game.