Heterogeneity and Persistence In Returns To Wealth
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Norwegian tax data reveals significant heterogeneity in individual returns to wealth, with a 180 basis point difference in median returns btw the 10th and 90th wealth percentiles.
“…We provide a systematic analysis of the properties of individual returns to wealth using twenty years of population data from Norway’s administrative tax records. We document a number of novel results. First, in a given cross-section, individuals earn markedly different returns on their assets, with a difference of 500 basis points between the 10th and the 90th percentile. Second, heterogeneity in returns does not arise merely from differences in the allocation of wealth between safe and risky assets:returns are heterogeneous even within asset classes.Third, returns are positively correlated with wealth. Fourth, returns have an individual permanent component that accounts for 60% of the explained variation. Fifth, for wealth below the 95th percentile, the individual permanent component accounts for the bulk of the correlation between returns and wealth; the correlation at the top reflects both compensation for risk and the correlation of wealth with the individual permanent component. Finally, the permanent component of the return to wealth is also (mildly) correlated across generations.…returns to wealth exhibit substantial heterogeneity. For example, in the last year of our sample (2013)‚ the (value-weighted) average return on overall wealth is 3.7%, but it varies considerably across households (standard deviation 6.1%). Furthermore, heterogeneity in returns is not simply a reflection of differences in portfolio allocations between risky and safe assets, and thereby compensation for risk-taking that mirrors heterogeneity in risk tolerance. Even conditioning on the share of risky assets in a portfolio, heterogeneity in returns is large and increases with the level of wealth. This result is confirmed even when looking at individuals with no private business wealth. Another remarkable finding is that asset returns increase with wealth. In 2013, the difference between the median return for people in the 90th and 10th percentiles of the wealth distribution is 180 basis points. The correlation between returns and wealth does not merely reflect risk-taking. We find that risk-adjusted measures of excess returns (the Sharpe ratio) increase with the level of wealth at the point of entry in the sample, before any investment decisions are taken…. We find that for wealth below the 95th percentile the correlation between average returns and wealth rank is largely due to a positive correlation between wealth and the fixed effects (individuals with permanently higher returns are wealthier). For wealth above the 95th percentile, it is largely driven by compensation for higher risk exposure among the wealthy, with a more limited contribution (one third) from the fixed effects….”
Andreas Fagereng, Luigi Guiso, Davide Malacrino and Luigi Pistaferri, “Heterogeneity In Returns To Wealth And The Measurement Of Wealth Inequality,” American Economic Review, May 2016, https://pubs.aeaweb.org/doi/pdf/10.1257/aer.p20161022
“…Individual returns average around 3 percent (2.43 percent at the median) and show substantial heterogeneity over the sample period. The standard deviation of individual returns ranges between 2.5 percent in 2009 and 6.1 percent in 2005. Similarly, the range (not shown) between the ninetieth and the tenth percentile varies, depending on the year, between 3.2 and 7.5 percentage points. Interestingly, the extent of heterogeneity first increases and then trends downward.5 Figure 2 shows that median returns increase with the household’s position in the wealth distribution. For example, households in the ninetieth percentile have median returns that are often twice as large as those of households in the tenth percentile, and the correlation with wealth also varies over time…”
Andreas Fagereng, Luigi Guiso, Davide Malacrino and Luigi Pistaferri, “Heterogeneity and Persistence In Returns To Wealth,” National Bureau Of Economic Research, November 2016, https://www.nber.org/papers/w22822.pdf
Ed Comment: I’m very skeptical of the conclusions. My experience is that almost all excess return comes from hidden (unaccounted-for) risks. For example, how do they account for liquidity risk, which probably adds 300 basis points of return for a given level of beta (correlation) risk (i.e. private equity outperforms public equity by 300 basis points for a given correlation with the market. My guess is that they don’t measure liquidity risk but that rich investors carry more illiquid assets to capture the 300 points (I do). Another example is duration risk. My guess is they don’t measure it. So I think more than showing the rich are savvy investors, it really just shows they are taking more risk, no surprise.
These are the second and third papers cited to support the proposition that the rich get higher returns. They overlap, but I found the data compelling. Both are using Norwegian data which documents both capital income and actual individual wealth stock, they looked at 1993-2013 so through two business cycles.