probability how to get rich

Probability: Why is it so hard to get rich

Everyone wants to get rich but it’s really hard. In this article I will explain why. We will look at the problem from the perspective of the probability of getting rich. Therefore, some of the ideas below are not common in most “get rich” articles and self help books.

Getting rich: The problem

You may have read some information on the subject and probably found out that most of it is useless. It is either irrelevant, for example invest like Warren Buffett, think like Jeff Bezos and so on. Or it is inapplicable to your circumstances, such as start your own business in the financial industry, on social media or otherwise.

You can’t start a business without any money or in an industry which is trendy but you just don’t understand.

Believe me I know where you’re coming from, I only had about £2,000 to my name 10 years ago and some of that was my car, computer and phone. Consequently, I have received a lot of unsolicited advice over the years on what I should be doing or should not be doing to get rich. As you may suspect none of it worked.

Probability of getting rich

Meet Pareto

Pareto was an Italian thinker who found out that the wealth distribution in Europe is governed by a power law. This is commonly known as the 80-20 rule: 20% of the population owns 80% of the wealth. The mathematics behind this are not for the faint hearted.

However, just think of a square. If it has a side of 2, the area will be 2^2=4, if the side is 3, then 3^2=9. In more simple terms imagine that you are in your local pub. The moment Elon Musk walks in the average wealth becomes in the billions.

Example

I know that the lowest 1% individual average earnings in the UK were £11,700 post-tax while the top 1% earned an average of £116,000 in 2017-2018. The maximum earnings of the 1st quartile (25%) were £16,300, the average was £22,100, the third quartile earned £32,300.

The top 10% start at £45,500 and the top 5% at £59,300. This is how the income distribution looks graphically:

get rich income distribution
Income on the vertical axis, percentile on the horizontal. Note how the curve goes vertical after the 95th income percentile.

You can see that if you are an average earner you need to increase your income by 5.25x to reach the 1%. On a pre-tax basis the multiplier is 7.2x.

Note that the road from the bottom 1% to the average post-tax is 1.89x and if you want to go to the top 10x post-tax or 15x pre-tax. The chances are stacked up against you!!

The sum of all paths

Power laws are a universal way things work, they are found in math, physics, biology and criminology. Even if you throw dice, the chance of throwing 7 is 16.67%, while the chance of throwing 12 is 2.78% or 6x lower.

On this occasion it is not due to a power law but the sum of all paths. There are 6 paths that lead to 7 and only 1 which leads to 12.

This is another important issue as many paths lead to a low or average income while few lead to a private jet.

Methods of getting rich

The previous section discussed the earnings of the employed and self-employed. You can see that the curve ends at around £120,000 post-tax.

A lot of aspiring entrepreneurs want wealth in the millions so the conclusion is that this is hard to achieve by working somewhere unless you become a partner at a top-tier consulting firm, a high-profile investment banker or make it to top management.

There are many ways to become wealthy, you can read different life stories on the internet, learn from other people, read about their struggles and their success. However, these cannot be replicated.

There is only one Bill Gates, you can’t be the new one. You may came up with the best idea, secure funding, have a great team but if the timing is not right it will not work.

Business & Entrepreneurship

There are a lot of stories about the successful start-up sold for millions or billions. The small firm which dethroned a giant multi-national or simply a story of someone who got rich.

Most of these contain two elements: success and failure. Some entrepreneurs fail a few times before they succeed and they claim to learn. I’m sure they do but does that bring success?

Success

Both success and failure are ambiguous. Success teaches us nothing because it is hard to determine the reason for it. There are a lot of moving parts in an economic situation and it is difficult to dissect them and analyse individually.

It is even more complicated to reconstruct the exact way they interacted with each other and with the environment considering the ever changing aspect of time. So when you hear “This is how I succeeded…” you are listening to a story not facts.

Failure

It is known that hindsight is a beautiful thing but is it really? We do learn from failure in repetitive fields and the professionals who benefit from it are electricians, doctors, lawyers, etc. Generally people who perform similar structured tasks. They perfect their skills through failure and it works really well.

Social science and economics are not clear cut so often you end up with some kind of bias as a result of a counterfactual assessment. Our brains add the missing pieces to a story to make it cohesive.

What is it then?

It’s probability, plain and simple. You’d often read that entrepreneurs failed a few times before they succeeded. I completely agree with this. However, they say how they learned, had a plan, etc.

I agree that they learned but I can’t know whether this had an impact on their success. I do know that they increased the chance of succeeding.

Probability of success

There is various data about the failure rate of start-ups. It ranges from 50% to 90% depending on the geography and criteria. The odds of a start-up reaching a unicorn grade IPO are quoted between 1 in a million and 1 in the billions.

The start-ups which survived and scaled up to £3 million turnover was 6.7% in the UK in 2016. However, if you fail a few times the probability changes. My assumption is that the outcome of each attempt is independent of the others. Here are the results:

One start-up attempt: 6.7% chance of success, 93.3% chance of failure

Three start-up attempts: 18.78% chance that at least one will be successful, 81.21% that all will fail

Five start-up attempts: 29.3% that at least one will be successful, 70.7% chance that all will fail

One failed attempt, the entrepreneur plans another 2: 12.95% chance that at least one will be successful, 87.05% chance that both will fail

Note that the probability of success for 1 out of 5 is not 6.7% x 5 = 33.5%. Furthermore, £3 million turnover doesn’t automatically equate to a rich owner. A company can have high turnover and still be making a net loss.

Is it a business or is it a job

Sometimes you’d hear stories of an engineer who quit his job to open a restaurant or a lawyer who started a corner shop. These businesses are expensive to scale up and rarely become a national chain.

When you are looking at a business you need to consider the earnings potential as you don’t want to end up with a pile of debt just to earn the same as you earned at your job, less or just declare bankruptcy. You can calculate this by using opportunity cost.

Is a start-up a good idea

Overall, a start-up is a low probability venture. Therefore, it is important for entrepreneurs to do careful financial planning. Failure is perfectly fine but I don’t want to see people losing all their money and ending up with huge amounts of debt.

The repayment of such debts may take years which prevents the entrepreneur from participating in subsequent ventures to improve his or her chance of success.

An important consideration is the capital required. Ventures with scale and low capital requirements mostly consume time. They have the added advantage that the low cost omits the use of venture capital (VC).

The problem with VC is that the funds are secured against shares of the company which dilutes the stake of the founders. Subsequently the entrepreneur cannot realise any profits for quite some time even if the start-up is successful.

An example of a successful low cost venture is Plenty of Fish, a dating website, sold for $575 million. You can read the story here.

Work and education

There is nothing wrong to want a business instead of going to work. In fact half of the workers in the UK want to start their own business so you’re not alone. The important part is to be smart about it and play your cards right.

Education

Some people start working straight after school, others go to university. There is a lot of debate whether going to university is a good idea. It worked for me but it hasn’t worked for others.

Either way the important point is to choose a highly paid occupation which delivers consistent earnings. It is also crucial to ensure that the range of the earnings is narrow.

You want a job where 70% of workers earn £60,000 with a range of £40,000 – £80,000, not one where 80% make £20,000 with a range of £15,000 – £250,000.

Choice of profession

It is important to choose wisely as this will have impact on future entrepreneurial attempts. The career of a doctor or a lawyer may be alluring in terms of a relatively quick potential of high earnings.

However, such careers present little opportunity for side projects as they have a narrow field of application. A hospital start-up would be very expensive.

There are other fields such as mathematics where the salary may be a bit lower than the one of a doctor. However, you can branch out in finance, economics, strategy, data science or even marketing. It is universally applicable. Furthermore, any math based projects can be completed by using computer software. You can easily work on a low cost side gig in your spare time.

What is the best career option

In my opinion the best option is to have two or more occupations: apples and oranges. It is 2020 and the world is very dynamic. The pandemic made us all rethink the stability of the economy so it makes sense to try to be as recession proof as possible.

The idea is to combine two professions, one which brings stable income and one which has scale. Following my previous example a lawyer by day, coder by night. This way you’d have two completely different occupations so if something happens and one becomes obsolete you just carry on with the other.

The added advantage is that the stable income job can support you while you work on your projects. It is important that the second one benefits from scale, e.g. if you are coding your product is easily accessible to millions of people without any additional distribution costs.

From a probabilistic perspective you mix a high probability of stable income with a low probability of a unicorn start-up. You also give yourself space to fail multiple times and thus increase the probability of success of at least one of your ventures.

Stock market

I have already talked about the performance of the stock market and I have also established that business in the form of Private Equity (PE) underperformed over the past 5 years. This presents a significant opportunity cost to entrepreneurs as PE firms are involved in the acquisition of established companies.

If you build a start-up you may become an acquisition target of a PE fund. The underperformance of PE means that the effort of stating a business may have gone to waste.

How successful are stock market investments

They vary depending on the type but the average yearly stock market return in the US is around 20% over the past 5 years. Nevertheless, 80-95% of retail investors lose money. Consequently, the chances of making it big in the stock market are similar to the success rate of start-ups.

The added disadvantage is that you need money to make money. There is little point in achieving 100% return on £1000 via a very risky strategy. You’d be much better off with 10-15% return on £1 million by using a moderate risk strategy.

On a positive note the stock market return gives a benchmark for all other investments. If your project is likely to achieve less than 20% return on equity you may start to question if there is any point in going forward.

High risk strategies that can land you rich
Trading

If you can borrow money at a low rate, 2-4%, invest them and achieve 10-20% return, you’d effectively earn 6-18% of profit in terms of the carry.

This is very high risk, the kind of thing that renders people bankrupt as the losses can exceed your own capital. You can find some examples of failures here. It is a common issue people encounter when trading CFDs.

Another problem to consider is that most brokers charge 7-9% for margin so borrowing is not cheap.

The pyramid

The pyramid is another high risk strategy which can bring high returns. You buy cheap out of the money options at a cost of $5-20 for one contract (the contract is for 100 options so the cost is $0.05-$0.20 for each individual option). A $5 contract can easily get to $100 or more under the right circumstances.

So let’s say you bought 50 contracts for $5 each, you pay $250 for 5-10% probability of profit. Then the price either goes up or you lose your money. If it goes up to $100 per contract for example you end up with a nice profit of $5,000 – $250 = $4,750. Then you repeat this until you get rich.

I rarely buy such options and my experience has been mixed. Out of four $5 trades I made $15 on the first, $20 on the second, $8 on the third and I think I will make a $5 loss on the fourth. It is a big percentage return (115%) but it is just pennies in absolute terms and I think it was plain luck as all of these options ended up worthless shortly after I sold them.

The problem with this method is that it rarely works as a big win will be averaged out by multiple small losses. It requires the purchase of options on stock which is expected to literally explode.

If there is such a stock you won’t be the first person who would have found out about it so the options prices will be inflated.

You can find an example of an epic options trade which turned $100,000 into $2.5 million by clicking here. Note that there was a very high probability of failure which would have resulted in a loss of $100,000.

Can you get rich by saving money

I’d be inclined to say no, however, savings provide the groundwork for larger scale projects. I have seen a lot of advice such as if you don’t buy one cup of coffee each week you will save £150 per year.

Yes sure and then what? First you need to earn money so I think that finding a high paying occupation should take priority over coffee. Once you have some money start saving but not on coffee.

How to save successfully

Focus on the big ticket items. Do you pay rent? If so save as much as you can and buy a house. Rent is a well known dead money type of expense and you have to live somewhere anyway. The purpose of this is not so much to make money on a house but to preserve capital.

Don’t buy a new car, buy a used one even if it’s just a month old or whatever fits your needs. The moment you drive away in a new car you lose 10-20% of its value. Cars are a money pit, especially in terms of the finance.

A lot of PCP schemes charge as much as 7% APR. We live in the era of low interest rates so check what your bank can get you. I brought mine down to 2.8% by not using PCP. The Retail price index was 2.8% at the time, so the effective cost was 0%. On this occasion is was cheaper to borrow the money than to pay outright.

No one got rich by spending everything so keep check on your credit card debt. Most companies charge in excess of 15% APR per year which is obscene in the low interest world. Find cards with settlement periods longer that 30 days. This will allow you to have access to your money for longer before you have to pay your bill.

A perfect situation would be if you have interest on your current account or other short term investments. This is how insurance companies make money. You pay premium then they invest it and withdraw later once payments to customers are due.

You can’t get away from utility bills but make sure you shop around. Check how much you pay for your mobile phone, going down from £60 per month to £30 adds up to £360 per year. Once you’ve done all that check the smaller bills: clothes, entertainment, etc. See if you can save something on these just bear in mind that you won’t necessarily get rich by living frugal.

Conclusion

Getting rich is a slow and difficult process. You may end up with piles of wealth overnight but the chances are pretty slim.

We found out that the probabilities are stacked up against us but if we keep trying we give ourselves a better chance to succeed.

The main drivers are a stable well paying job, savings and wise investments in business or the stock market. It is important to choose investments which have scale and can achieve outsized returns.

It wouldn’t make any sense to throw all of your life savings in a project which would barely return the wages you are already getting from employment. Remember, get rich or keep trying!