The Income Optimization Trap

Oftentimes I wonder what leads individuals to make certain decisions. More often than not we focus too much on the inconsequential details of our lives like our weekend plans, relationships with acquaintances, and not enough time on the truly consequential one’s - should you buy a house, how do you optimally grow your wealth, what career should you pursue, decisions impacting your health, and many others. One reason for this error in priority is that we don’t quantify the probability and impact of wrong decisions.

Sure, not joining your friends out one night might feel like a huge loss at the time, but what do you think will be bigger in 30 years: Your decision to stay in and prioritize health / work or missing a couple of nights out?

Being interested in these decisions, I began thinking why people make certain employment decisions. Specifically, what is the optimal way to grow your income?

As I began thinking more and more about this it lead me to imagine a hypothetical income progression of a person paid a salary versus someone pursuing their own venture.

As you see in the graph above it is clear that an entrepreneur has more upside over a longer time horizon than the majority of employees, so why is it that not everyone is an entrepreneur and a corporate job is the goal for so many. It’s obvious that some people have different levels of risk aversion and might value stability more than returns, but why wouldn’t the most ambitious optimize for the highest overall potential return (they are the best aren’t they?).

Now let’s ask the question again - what would you choose here?

At the beginning of your career, it is clear that the right choice is to focus your energy on your career and pursuing your own venture is a waste of time. Consider your expenses as a new grad - student loans, rent, and bills all of which make pursuing entrepreneurship unattainable.

But when does that decision change? When might it be worth your time to not solely focus on your career? The point is when your income from your career hits an inflection point - more specifically, when your income flattens.

The Flattening

We can visually see this happening once the growth rate of your income begins to slow. How this looks for you is that your 10-15% salary increases turn into 5-10% which progressively decreases over time. Yes, it is at a higher dollar value, but eventually these increases will slow to an end. The once salary increases turn into more and more responsibility and less and less pay increases. Instead the pay increases are replaced with responsibility and promises of a job at the next wrung up on the corporate ladder.

If earnings from a salary didn’t eventually stop growing then every employee would just need to be working long enough until they earn a million dollars per year. That can’t be true if the CEO of a company averages an $800k salary. Now $800k is obviously a fantastic sum of money for someone to earn, but how many people at a company are the CEO versus how many people are waiting for a promotion? Now imagine the taxes they pay on this earned income. So who does better than the CEO? Well that would be the person who took the risk to start the company to begin with - the owner.

What starting a venture gives you isn’t income, but ownership and ownership (in the right thing) has been the key to wealth generation for millennia. In today’s day and age it has never been easier not only to learn and develop new skills but to start companies. The largest companies 100’s of years ago gained scale through physical ownership, however, today’s most ubiquitous companies are digital and massively profitable due to their scale and extreme profit margins.

Going back to the original question. If we know the path to riches isn’t income, but ownership why do we ambitiously pursue these opportunities at the expense of potentially uncapped profitability?

Life Happens

Ask any 20-something-year old person where they expected their life to be when they are in college and then ask them again after 15 years. More often than not those ambitious goals have been swapped with stability. Part of the reason is because individuals are biased towards accomplishing certain benchmarks. We live and die by the calendar. Not married by 30? Not a home owner by 35? Don’t have kids yet? All viewed as marks of failure.

The pressure to live to others standards and on their timelines is real and leads many to make the wrong decision. These decisions while not necessarily ruinous put individuals in a position where they are fragile. Not only can you not take the financial risk necessary since your income is spread so thin, but you also lack the time required to work on anything outside of your day job. Eventually the income that provided you opportunity enslaves you.

Uncertain Returns

While the returns are potentially unlimited your expenses to start a business are real.

People are loss averse and the concept of doing something that costs you money and time, but offers no direct payoff is enough to make people never start. You might fail multiple times, in fact, that is most likely. The survivorship bias is evident by how few and large the winners are. While there are so many hidden failures, imagine what could have been started because people weren’t afraid of taking that risk? How much better would this world be because of a small, uncertain, risk taken to pursue an interest with uncertain returns.

The solution to this is that one should pursue their career as aggressively as possible until the returns gained from that level of investment decreases. Once your returns hit the inevitable inflection point and begin flattening, look towards other income sources to grow and eventually replace or supplement your wage income.

We get older by the second, make sure the decisions you make aren’t based on external pressure, but based on your own goals. Know that by living on your own timeline you have given yourself the gift of time. This gift gives you the most opportunity to continue pursuing these longshots. Take a step back and look at what has the largest overall return rather than the steepest short term return.

Most importantly, think long-term and avoid short-term solutions for long-term problems.