Wealth, Actually Read online

  On the flip side, take somebody who grew up dirt poor and wins the lottery. You’d think they should be able to manage their spending, because they’re coming from a life of lower spending. However, research shows most lottery winners end up bankrupt because they are not equipped with the tools to understand what levels of spending their new wealth can and can’t support. Their spending often elevates too quickly before they realize where it’s leading them.

  Wealth Generated from Current Income

  Wealth generated from “current income” refers to situations where people’s wealth comes from high salaries, but not necessarily equity in the businesses they’re paid from. For example, a professional athlete or investment banker earning a salary of $3 million a year are both receiving big streams of income, but without saving and investment, they aren’t building their balance sheets with assets that will generate income when their professional lives end. Their profession is their asset, which can be a dangerous feature when the professional athlete gets injured or the investment banker retires from the high-paying job or is cast aside for a younger or cheaper replacement.

  Wealth Generated from Assets or Businesses

  Wealth that comes from building an asset for the future is a different situation. This could be the person who’s building their business and taking a salary from it. They’re taking money out as needed, but they’re also building a valuable asset that can be sold later or used to generate income even after the owner has retired. Equity businesses could be anything from a tire business to a song portfolio to a private equity fund.

  Business owners often pour their earnings back into their business so the business grows and throws off an increasingly larger amount of income. It’s common for real estate investors to do this. When the desired amount of income has been generated, they use that money toward living their life accordingly. The hope is that someday they’ll have to decide whether to sell their real estate investments or move those assets on to the next generation.

  When a business owner considers the prospect of selling their income-generating business, often to help fund their future income and their legacy, there are interesting issues to be dealt with. Who are they going to pass the business ownership and operations to, if that’s the goal? Quite often, it’s passed on to the family. That can lead to problems if the next generation is not equipped, prepared, or interested in operating that business. Because of this obstacle, the business owner will often sell their business instead of passing the business on to future generations.

  Corporate Executives

  The wealth of the corporate business executive tends to be much more liquid than that of the private business owner. Corporate executives tend to get paid in cash and/or stock. This requires deeper analysis into their wealth planning and management. While the stock can represent a substantial amount of money, it’s often not enough to cover the spending needs of the corporate executive in retirement. I try to coach corporate executives to increase their savings as much as possible before retirement, so they don’t have to stumble too much upon retiring when it comes to funding their lifestyle.

  It’s also vital to inculcate the value of diversification to executives who have built their wealth through one company. Many executives believe they still know the intricacies of the companies they ran long after they had left. That can be an expensive (and future-altering) mistake.

  Hedge Funds and Private Equity

  Hedge funds and private equity wealth, as I alluded to earlier, can be illiquid. Hedge fund folks tend to be paid big bonuses and acquire ownership in the funds they manage. But this type of asset tends to be difficult to sell, either because there are few buyers or because it’s a regulatory and tax headache to do so. We have not reached the point in our history where hedge fund operators have begun to significantly liquidate their hedge fund assets and wealth for the purpose of diversification.

  Many hedge fund and private equity principals want to hold on to general partnership interests because that’s the business model of the fund, but we haven’t seen anybody really liquidating their interests yet because the first generation of hedge fund managers hasn’t gotten old enough to “retire.” Even with fairly average recent performance, their businesses generate so much cash that it’s difficult to turn that spigot off (especially for the employees of the fund). As it relates to this type of wealth, the first big round of industry-wide succession planning is just beginning.

  It’s unclear what’s going to happen when it’s time to liquidate or transfer that wealth. Many of the owners of these funds want to transfer the wealth to the next generation, but recognize that the talent to run these organizations doesn’t reside within the family. This creates big and complicated succession planning issues, and the industry is only scratching the surface of their impacts. It’s a trend to keep an eye on as we move forward.

  Inherited Wealth

  Inherited wealth sometimes looks like lottery wealth, except that inheritors may have been coached well by parents who have ingrained good wealth management concepts in the next generation. Other times, inheritors haven’t been coached at all, and that’s where you might start to see a sense of entitlement that can become a threat to wealth.

  An old maxim warns that wealth often goes from “shirtsleeves to shirtsleeves in three generations.” The first generation builds the wealth, the second generation maintains it (or spends it), and then the third generation isn’t imbued with the characteristics, work ethic, or values needed to preserve the wealth that remains or build their own wealth to sustain the standard of living they enjoyed growing up. By the fourth generation, there is usually a lot of looking back in regret. Unguided inheritors of wealth are the usual cause, but there is a numbers game at play too.

  Take a common example, a husband and wife who have built a successful company. The company has provided a nice income to the spouses who have also buckled down as they took the risks and invested in the growth of the company. They have two kids. The family’s expenses increase. Then those kids get married. There are now six people being supported by the wealth of the one company.

  Then, four grandkids come along, and they grow up and get married. Now, you have fourteen people spending that wealth. The wealth (in this case the company) now needs to work that much harder, and grow that much faster, to keep up with the new level of spending. The wealth can’t keep up (except in the rarest of circumstances), and the family sinks back into the financial condition they began with three generations ago. From “shirtsleeves back to shirtsleeves.”

  Specialty Wealth

  Specialty wealth could apply to athletes (as we discussed before) as well as to other types of artists and intellectual property creators. Artists often have two sources of income: they’re paid for performance, and they’re paid for the art (intellectual property) they create. That’s why you see actors who suddenly have production companies. That’s why the musicians who get paid well not only perform their hits but also write the music themselves. The intellectual property (songs, books, art, or productions) are what ultimately get licensed and provides a revenue stream that lasts long after the voice has given out or the muse has left. This applies to painters, authors, and other creators.

  These artists are the type of people who can benefit most from professional wealth management. Money and numbers are often not artists’ love, interest, or comfort level. They are experts in the pursuit of their art. Educating artists on what wealth can and can’t do and providing them structure around their costs can lead to great results and more stable futures. Hopefully, by doing this, they can avoid the worst-case scenarios we hear about, where highly successful artists and athletes find themselves in financial straits later on in life.

  Wealth from Legal Settlements

  Legal settlements are closely related to lottery settlements but differ in one major way. There is an expectation of a sum of money at the end of a legal proceeding, so there is u
sually little surprise at the outcome. However, knowing what might be coming and preparing for the actual settlement are two different scenarios.

  People who receive compensation from a lawsuit have usually suffered a form of damage, either physical or emotional. Money can be the secondary outcome as the claimants have mental or physical injuries to rehabilitate and lives to rebuild. Financial advisors do their best work when helping these people analyze their future expenses. They make sure the wealth from the legal settlement is invested and structured in such a way that their new lives are financially supported.

  Divorce settlements are a common legal settlement. The outcome is rarely a surprise as both parties are often fully aware of the circumstances of the breakup. They often involve spouses who don’t have a good understanding of where their wealth actually comes from. In this way, divorce settlements can end up functioning like a lump sum payment, similar to that of a lottery winner. However, given the amount of pain involved in ending a marriage, a divorce settlement is much more challenging emotionally.

  I take extra care when working with divorcees. No matter which sex is involved, the pain of the divorce process can leave all parties in emotionally difficult states. Spouses may have limited experience in the world of finance (or at least in their own finances), so the education process is important. Beyond teaching them the blocking and tackling of investing and budgeting, I help that kind of client understand where they are and what they need and help them inject realism into their new lifestyle going forward. That’s often the best service I can provide. By helping these clients feel more comfortable in their new financial situation, I’ve helped them to rebuild their lives and go on to do good things on their own.

  What Is a Liquidity Event?

  A liquidity event is when you convert an asset into usable, liquid wealth. This can be driven by a planned event, such as the sale of a business, the birth of a child, or retirement. It can also be driven by an unexpected event, such as a lottery win, legal settlement, unexpected inheritance, or death.

  It’s any event where the usable assets have increased, and the amount of structure around that wealth has, in many cases, decreased such that it’s an event to be planned for in advance when possible.

  When Can Liquidity Be a Threat to Wealth?

  A liquidity event can unlock great wealth. It can represent an expansion of options or relief from a draining personal or professional situation. However, liquidity events bring in new sets of threats, risks, and conditions. When liquidity events arrive—whether to fund your retirement income stream or legacy objectives with family and philanthropy—several types of threats can emerge. We’ll further analyze these threats to wealth later in the book, but here’s an overview of the most common threats my clients encounter.

  Spending

  Spending is an obvious threat to wealth. However, the mistakes of blowing through large sums of money without keeping an eye on the future get repeated over and over again. Having a good handle on your spending is vital. Once a dollar is spent, it’s not typically coming back. If you go into the world with $10 million and you spend it down to $6 million, it takes an awful lot of work and discipline to get it back up to $10 million. And it’s particularly difficult if your excessive spending got you into that predicament in the first place. If I can teach clients to think of a $10 million windfall as access to an annual revenue stream of $400,000 (assuming a 4 percent annual return on $10 million), the chances of that wealth’s survival (and even growth) increase exponentially.

  Poor Communication and Bad Decision-Making

  Poor communication and bad decision-making are major threats to wealth. Many mistakes occur when financial decisions are made with emotion, angst, greed, or irrational exuberance. This can happen in situations where plans have been put in place, but those plans were not communicated well to the family members, inheritors, or advisors. That lack of communication can have destructive effects.

  One common example is when family members have been left in the dark on the wealth planning, and they don’t start discussing the wealth until the patriarch dies and the estate is being settled. The patriarch may have put several important wealth initiatives and structures in motion but communicated none of it to the family. The family is not used to (or comfortable with) discussing wealth. However, death and the IRS wait for no one—those discussions have to happen then. That is not the ideal moment for a family to be having those discussions for the first time. Emotions will be raw. Information is usually incomplete. There are long-held assumptions and grievances. The structures can be complicated. At best, the family members can go their own way with little fanfare. At worst, severe conflict can occur, ending relationships and leading to expensive litigation. The most unfortunate outcome is that the benefits of working together can be irreparably lost.

  When communication is poor, people lose the benefit of investing with scale and the benefit of learning from others’ mistakes. There are often hurt feelings when people don’t communicate what their objectives are (or aren’t). This can cause an information shutdown. The lack of communication, the lack of shared values, and the lack of a shared direction for the wealth can lead to a divergent and intractable set of opinions on how to proceed. Instead of being used to take advantage of future opportunities and avoid future pitfalls, shared family knowledge evaporates. This can lead to bad investment decisions or ham-handed wealth structuring that promotes (rather than prevents) the generational destruction of wealth.

  Poor Tax Planning

  Taxes are a component that always needs to be dealt with. Poor tax planning can lead to lower returns. While most people structure their affairs so as to pay as little tax as possible, many mistakes are made in poor tax planning. Each dollar that goes to the government is one less dollar that goes to the family, its successive generations, or the philanthropies and causes they support. When someone pays more taxes than they need to, it becomes a threat to one’s wealth.

  Lawsuits and Creditors

  If your teenage son borrows the family car and runs over someone, it’s likely the resulting lawsuit is going to come directly to you, the owner of the wealth. You have the deepest pocket. You may have had $10 million and thought you were set for the rest of your life, when all of a sudden, $5 million of that goes to the family of the person your son just ran over. Because of scenarios like this, lawsuits are a significant threat to wealth.

  Bad Investments

  Finally, bad investments are a prominent threat to wealth. When there’s a lack of discipline around the investing function and a lack of understanding of the risks involved with different types of investments, wealth can disappear due to bad investment choices.

  Ideologies for Increasing Wealth

  Beyond preserving wealth and mitigating threats, there are many opportunities to increase wealth. Let’s look at the basic investing ideologies that can help to increase wealth.

  Concentration vs. Diversification

  One of the standard bromides in the industry is that diversification is the driver of a good investment strategy. However, for those looking to become wealthy, one has to make concentrated bets. Putting all of one’s eggs into one basket is dangerous. If the investment craters, and without the benefit of other investments or savings to soften the blow, you’re left with nothing. However, by having not allocated assets to other safer investments and if your investment explodes higher, you stand to reap all of the rewards. Your investment returns and your assets will not be dragged down by your plodding, safer investments.

  It’s the big concentrated bet that generates the big win. Ask Mark Zuckerberg about Facebook. He bet it all and turned down many chances to cash out and diversify. As the company rockets higher, he is one of the richest people in the world.

  Diversification is the tool to use in order to stay wealthy. By having multiple investments within different asset classes, withstanding a huge loss in one of the investments becomes
easier.

  The Benefits (and Risks) of Leverage

  Leverage is the borrowing of money to increase one’s personal wealth. An example of this is when a private equity group raises a million dollars, then borrows $500,000 more from a lender, resulting in a total of $1.5 million to invest. If they’re able to triple their money to $4.5 million in three years and repay the $500,000 to the lender (with some interest, which we will ignore for now), then they’ve generated higher profits by leveraging with borrowed money. Their investment would be worth $4 million, as opposed to the $3 million they’d have if they had not used the leverage (tripling their money on only $1 million, as opposed to tripling their money on the leveraged $1.5 million).

  Now imagine if the manager was able to borrow $3 million instead of $500,000. This would give them $4 million to invest. If they tripled their money, their investment would be worth $12 million. After paying back the $3 million loan (ignoring the interest again, to keep things simple), their investment would be worth $9 million. Again, had they not “levered up,” their investment would have been worth only $3 million (for roughly the same amount of work).

  When people try to understand why hedge fund and private equity investors are so wealthy, it’s often leverage and borrowing that has gotten them there. It allows the investors to drastically increase the scale at which they make investments using other people’s money.