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How investment returns help to explain wealth inequality

Risk, return, and skill in the portfolios of the wealthy

This is an interesting piece on portfolio returns of the wealthy. Intuitively, and according to data, we see that during periods of economic expansions income and wealth inequality increase due to higher compensation (bonuses) and investment returns, respectively. This study finds evidence of the latter from Sweden.

The key here is that the investments of the wealthy tend to be more risky. Think of this as the wealthy use leverage in their portfolios. Said another way, while the average middle class citizen likely uses basic mutual funds, a wealthy investor will use options, futures, private equity, or other customized separate accounts that use leverage to magnify returns.

Now, from the article:

Wealthier households allocate a substantially higher fraction of total gross wealth to risky assets compared to the median household. The share of risky assets increases monotonically with net worth, reaching 21% for the median household, 62% for the top 1%-0.5%, and 95% for the top 0.01%.

And, in terms of returns:

As a result of these risk exposure patterns, the expected return on total gross wealth monotonically increases with household net worth. Compared to the median household, the expected return on total gross wealth is 2.7% per year higher for the top 10%-5% of households, 4.1% per year higher for the top 1%-0.5%, and 6.2% per year higher for the top 0.01%.

This study also finds that wealthier investors do not have better investment picking skills. This is intuitive as there is a plethora of research showing that investment skill is does not explain better returns. Rather, the amount of exposure to risky assets is the key determinant to better returns. In other words, the higher the beta, the better the returns during bull markets.

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