Peter Hodson: It takes money to make money, but once you have money, the advantages increase

The perfect amount of money is not more; the perfect amount of money is enough. It is a great quote and a good philosophy.

Too many investors chase returns when looking for the big score. Too many investors have enough money but spend all their effort on getting more. It can make for a sad, lonely life, despite the appearance of success.

But let’s focus on the advantages that really rich investors have over you and me. It takes money to make money, but once you have money, the advantages increase. Here are five ways the rich have an advantage over you.

They can withstand market corrections easier

You can largely ignore even very major market crashes if you have $65 million. Suppose the market takes a sudden 25 per cent hit. In such a scenario, you will have about $49 million left.

First, we are pretty sure you are going to be just fine with $49 million. Second, if you actually take any losses by selling stocks, you can reduce your capital gains tax bill. Third, assuming five per cent yields, your $49 million is still going to generate $2.45 million annually, and you can use that money to start buying stocks at their depressed levels. Win, win and win.

They can defer taxes much easier

In June, the federal government bumped up the capital gains inclusion rate. Lots of investors — including yours truly — were angry about this. Not only does it increase your personal taxes, but it was very shortsighted. Canada has a productivity crisis and taxing risk capital at higher rates is not the way to improve productivity. But, ignoring this aspect, it barely mattered for the rich.

Back to our example: if our investor has $49 million now and capital gains taxes go up, what do you think they do? They don’t sell stock, that’s for sure. They borrow money against their assets. This defers taking capital gains and allows them to, perhaps, sell stocks later when a new government lowers the capital gain inclusion rate in the future.

Another bonus: the interest on the borrowed money is tax deductible, assuming the investor has at least some dividend or interest income to report.

Interest on debt for investment is tax deductible

As noted above, investors can, in many instances, deduct interest charges from their taxable income. So, rich investors get lower interest rates (because they are a solid credit risk) and they can now deduct that interest.

Suppose an investor gets a loan at seven per cent. Depending on the situation, the after-tax cost of that might be 4.5 per cent or so. Considering the S&P 500 is up 17.3 per cent this year alone, add in another 0.42 per cent from the decline in the Canadian dollar, and interest costs of 4.5 per cent are easily absorbed by market gains.

Now, the deductibility of interest applies to all investors, not just the rich. But the rich investor’s higher tax rate and better ability to borrow large amounts of money remain a big advantage to them.

They can buy alternative, non-correlated assets

I had a boss who once spent $9.5 million on a Monet painting. This was decades ago, and I have no idea if that painting increased in value over the years. But I know one thing: regular investors are not dropping $10 million on a piece of art.

The key to alternative investments, such as art, coins, hedge funds, real estate, private equity and so on, is that they are typically not correlated to equity markets. If a rich investor owns a bunch of alternative investments, their portfolio is more diversified than yours or mine. Better diversification smooths out market gyrations and allows investors to stay calm when markets crash. Advantage: the rich.

More ways to defer and reallocate income

U.S. estate taxes can take a serious bite out of one’s estate for Canadians with a very large amount of assets in the United States. But setting up a personal holding company can avoid this tax hit, which can be as high as 40 per cent, depending on the circumstances.

Similarly, setting up family trusts allows rich families to spread out income over multiple beneficiaries, thereby reducing tax burdens and rates.

Holding companies and trusts cost money to set up and administer, but they are certainly worth it for wealthy families. These are all legal, of course, and the government is taking steps to reduce some of the benefits, but for now, it is another advantage for the wealthy.

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