From Gerd Kommer and Jonas Schweizer
“When you have won the wealth accumulation game, stop playing it.” – William Bernstein, neurologist, financial advice author, asset manager
In the context of investing and investing, it is a rarely addressed issue: the difference in the success factors for get rich versus stay rich. Most financial advice books, financial journalists and finfluencers ignore this difference by directly or indirectly giving the impression that there is little difference between building wealth and maintaining wealth when it comes to the basic rules of smart investing. A big fallacy.
In this blog post we will show that in the life cycle phase of getting rich - the phase of building wealth - and in the phase of staying rich (wealth preservation, asset use, asset protection) a given investment situation should often be decided completely differently if you want to maximize the chances of success. Individual investors who recognize this will achieve better financial results and be more mentally and emotionally satisfied.
We try to show that in the economic life cycle phase of wealth creation (“VA”) and in the phase of asset protection (“VS”), a given situation should often be assessed and decided quite differently if one wants to maximize the respective chances of success. Individual investors who recognize this will achieve better financial results and be more mentally and emotionally satisfied.
We list twelve criteria below where smart decisions in the VA phase and the VS phase differ significantly. But before we get to that, we need to briefly address three aspects that are important in understanding our twelve criteria.
Aspect 1: The VA phase and the VS phase can, but do not have to, overlap in the life cycle of a private investor household. There is little or no overlap for most retail investor households, whose members have been employees all their lives and typically retire sometime between 55 and 67. This also applies to a successful start-up who sells his company at the age of 40 for 9 million euros and then decides to “stop working for money.” However, the situation is different for economically successful, “more conventional” entrepreneurial households. In their case, the two phases overlap if such a household has accumulated substantial assets quite early in the life cycle (e.g. at 40 to 45 years of age) that now needs to be protected. Then the members of the household who earn money will often continue to work for 20+ years. During this long period of employment, the household does not yet need the assets it already has to cover living expenses.
Aspect 2: The majority of wealth growth in the VA phase almost always comes from the successful increase and utilization of human capital [1] and/or from entrepreneurial activity and not from part-time investing in real estate and securities as a private investor. Becoming “really rich” almost always requires entrepreneurial activity, leaving aside lavish inheritances, marrying rich and high lottery winnings. [2] As an employee, you can become wealthy to a certain extent on your own, but rarely really rich. This is defined here as the wealth level at which a person “never has to work again” - even if the real estate or stock markets and the market for interest-bearing investments produce drastically below-average returns in the next 20 or 30 years and at the same time the person can afford (not necessarily actually allow) a lifestyle that corresponds to that of the top 5% of the population.
Aspect 3: Our comparison in Table 1 is only applicable to a limited extent to the circumstances of “super-rich households”. For the purposes of this book, we define these as households with a net worth of 20 million euros or more per household member. Also, some other statements in this book that apply to “wealthy/wealthy/rich” households may be less universally applicable to super-rich households.
Now let’s get to the actual VA versus VS distinction. The comparison of twelve fundamental differences represents the ideal target state in both phases. Unfortunately, the current state unfortunately looks different for many wealthy households, especially in the VS phase. This is often because these households do not recognize the VA versus VS dualism and, to their own detriment, act and behave in the VS phase as if they were still in the VA phase.
There are also private households in the VA phase that want to become wealthy but use VA rules and methods to do so. This is also not very promising in another way. We believe that the comparison in Table 1 is essential to understanding what we want to convey throughout the book.
(1) Life cycle phase and age of the investor or household
[*] Return sequence risk: For a portfolio from which withdrawals take place, the effective average return in a given observation period (e.g. 20 years) is largely determined by the order of the period returns. Poor returns at the beginning are more detrimental than poor returns later.
(2) Primary economic investment objective of the household
(3) Use of Assets
(4) Investor's optimism-pessimism spectrum regarding personal finance
(5) willingness to experiment with one's own human capital or entrepreneurial activity
(6) Risk appetite
[*] Our choice of words for “a risk take“corresponds to the English terminology “to take a risk”, instead of the unusual English wording “to carry a risk”. “Take” has the advantage here that it is the active, acting The role of the household in relation to the consciously selected risks is highlighted, not a passive “immature” role, as one might think in the case of “bearing a risk”.
(7) For entrepreneurial households: concentration of wealth in the entrepreneurial sphere
(8) Geographic concentration of wealth
(9) General cluster risk tolerance for investments
(10) Degree of concentration of ownership in one person
(11) Credit leverage (leverage)
(12) Most common or most important cause of high losses at the total asset level in entrepreneurial households
[*] These entrepreneurial risks often have an existential character, e.g. B. entrepreneurial liability risks, which in the worst case can lead to personal insolvency, health risks due to extreme work commitment, family risks, i.e. h. Marital and family crises, alienation of children caused by too frequent absences and stress.
Why is recognizing the differences between the VA phase and the VS phase so important for wealthy retail households? The answer is basically banal:
First of all, it makes little sense to go through the trouble of getting rich if you then lose everything again because you make mistakes that are impossible or difficult to correct while staying rich. In the following section, “‘From rich to poor’ happens more often than you think,” we show how often such mistakes occur and in what form they occur. These mistakes can often no longer be corrected because the remaining lifespan is too short and health is too impaired due to age.
Second, the fundamentally different goals between the two phases cannot realistically be maximized at the same time. They contradict each other to a considerable extent. This incompatibility is based on the well-known iron law of investing, which we all know well in theory, but which at the same time only a few wealthy people consistently and without illusions put into practice:
The fact that small and large financial risks do not materialize in the majority of cases does not mean that these risks did not exist ex ante. They could have materialized. [3] Therefore, wanting low risks means accepting low returns. The three most important risks that we are primarily referring to here are default risk (also called repayment risk or counterparty risk), volatility risk and illiquidity risk. In addition, many other types of risk can exist in specific individual cases.
Even the banal self-evident fact that opinions differ greatly even among sensible people when assessing the size of a given risk ex ante and ex post does not change the No Free Lunch Law.
Wanting to take on very little or no risk (especially in the form of the three risk types mentioned above) for one's own assets, as can be sensible and correct for the VS phase, means having to accept a return close to zero in the long term after taxes, inflation and costs. That is how it is today and how it has been for the last 100 years.
We know from our advisory practice: Many private investors in the VS phase nod with a yawn when someone recites the iron law of investing, the no-free lunch law, but deep down they still do not accept the uncomfortable truth it contains. The proof: If they accepted the law, they would invest differently in the VS phase. This can be seen, for example, in a downright bizarre aversion to low-risk and therefore low-yield investments (such as high-quality bonds) in many cases and this is reflected in the tolerance of often enormous cluster risks, for example the cluster risk of one's own company, in German real estate or the liability of one's private assets for bank debts from real estate transactions or company loans.
The causes of this financial schizophrenia in the VS phase of rich households are diverse. The most important include:
(a) Lack of knowledge about the history of real estate and capital markets, particularly the fact that asset class returns have historically been well below what we generally assume, while at the same time their risks have been higher.
(b) The fact that many investors defiantly ignore how surprisingly often (i) unforeseeable “black swans”, (ii) too much leverage (debt) and (iii) too little diversification or, to put it the other way around, too high concentration risks, gradually decimated the assets of rich families and in some cases even in a short period of time.
(c) Greed, i.e. the inability to mentally accept low but secure returns. This greed is often coupled with the naivety of buying into the tempting but unrealistic “return bait” offered by the financial industry, some advice book authors and finfluencers.
(d) Overconfidence: The belief that one's own economic success in the past in risky (and specialized) activities as an entrepreneur is proof or proof that one can also use this success with the associated returns in other financial fields, e.g. B. real estate, individual stocks or private equity, could continue in the future, more or less risk-free.
(e) The sometimes literally compulsory deferral of tax payments into the future that would be due on the sale of company shares “now”, even though these tax payments would be due at some point anyway. This behavior helps ensure that assets cannot be pulled “behind the firewall” (into private assets that are not liable for company risks).
Finally, we would like to let three experts speak about the difference between becoming rich and staying rich:
Conclusion
Wealth creation/getting rich and wealth protection/staying rich are two structurally different phases of the financial life cycle of a wealthy family or individual. The VS phase requires a fundamentally different mindset from the decision-makers in a wealthy household, i.e. different knowledge, different priorities, different goals and different actions than the VA phase. The more consistently and clearly the household perceives and carries out the transition from the VA phase to the VS phase, the more economically successful and humanly fulfilling the result will be for it.
A household that has partially or fully entered the VS phase must (a) derive its return expectations from the main objective of asset protection, and no longer from the returns that the household achieved in its own VA phase. (b) He must now actively and “aggressively” reduce cluster risks, cluster risks in relation to the real estate asset class, cluster risks in relation to assets that are economically exposed to the political risk of Germany and cluster risks in relation to his own company if it is an entrepreneurial household.
Endnotes
[1] Human capital is the present value (present value) of all future net salaries or other professional income of a person or household that have not yet been collected.
[2] In our blog post “How do you become really rich?” We will explain in more detail which paths, techniques and investments statistically lead to high wealth and which do not. There are misconceptions among large parts of the population here.
[3] A wise definition of risk by the well-known financial economist Elroy Dimson reads accordingly. “Risk means more things can happen than will happen.”
[4] Original: "It takes a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten times as much wit to keep it."
[5] Original: "Any fool can make a fortune; it takes a man of brains to hold onto it."
[6] Original: "Anyone who has become rich twice is dumb. Why would you risk what you need and have for what you don't need? If you are already rich, there is no upside to taking on a lot more risk, but there is disgrace on the downside."