By Henry Ford

There is a saying “From clogs to clogs in three generations”  This comes from the idea that the first generation establishes business’s, the second builds it and the third loses it.  This plays out when tracking what happened to millionaire families in the United States.

Cornelius Venderbilt the 19^th century rail and shipping tycoon died in 1877 as the wealthiest man in the world.  70 years after his death the wealth was largely dissipated. If his family had invested in a boring diversified portfolio of US companies, spent 2 per cent of their wealth each year, paid their taxes, each one living today would have a fortune of more than $US5 billion.  What went wrong?  Is this unusual?

In 1900 the US census recorded around 4,000 American millionaires.  If a family had invested $US5 million back then in the US share market and spent at a reasonable rate that family would have generated about 16 billionaire households today.  There are around 700 billionaires in the United States today and it is a struggle to find any who can trace their fortune back to a millionaire ancestor in 1900.   Further, fewer than 10 percent of today’s US billionaires are descended from members of the first Forbes 400 Rich List published in 1982.

Here are some common ways that somehow these millionaire families gave up their head start.  They either took too much risk or too little, they might have spent too much or not adjusted their spending to changing circumstances.  Above all though they did not have a core planning framework that gave them a basis for making decisions.  That left them susceptible to chasing the new hot thing, buying high, selling low and paying exorbitant fees for poor advice.

The most important decisions are of the how much variety.  How much should you buy of a good investment, how much should you spend today, how much to insure against a low probability, but high consequence events.  Why is sizing important?  If you pick a bad investment but not too much, then when it goes through the floor you can still regroup and go again.  Probably you will be much wiser for the experience.  If you pick a great investment but commit too much you might not be able to ride the inevitable ups and downs that come  from even good investments.

It seems this failing is widespread in investors.  For example, individual investors underperform the market both in absolute and risk adjusted terms.  Much of this comes from having too much or too little at risk and usually at just the wrong times.

Consider this experiment in 2013 published in the Journal of Portfolio Management.  61 qualified and quantitatively trained individuals were told to play a simple coin flipping game.  They were informed that there was a 60% chance of landing on heads.  They were given $25 and told they could bet any way they wanted.  At the end of the game they could keep their winnings to a maximum of $250.  They were given enough time for 300 flips.  Most sensible strategies would have an expected payout of $250.  So how did they do?  More than 30% of them lost money, 25% lost everything and only 20% made it to $250.  Well short of the 90% who logically should have.  Even qualified people are able to destroy wealth even when the odds are in their favour!

Key Take Outs

• Curiously, sometimes it is easier to make money than to keep it.
• A decision-making framework, carefully thought through and documented should curb the excesses of human nature.
• The market provides a risk adjusted return that compensates for risk.  Being diversified and holding the course through the ups and downs will bring rewards.  This strategy has the highest chance of success.
• Most of us don’t start with a billionaires inheritance.  But financial security still matters to most of us.  The lessons billionaires have demonstrated are learnings for us all because we all need to best outcomes from whatever resources we have.
• A financial coach can give us the framework, but also help us stay disciplined.  Even the most qualified individuals are tempted to move away from a sensible strategy.  Greed and fear are never far away. 

A fully summary of an excerpt from the book The Missing Billionaires, A Guide to Better Financial Decisions published by John Wiley and Sons can be read in the AFR.  This is a summary of that article.