The Best Way to Lose $5 Billion Dollars

I caught an Uber the other night to a function in South Yarra. I was caught in peak hour traffic, so the conversation with my Uber driver went a little deeper. My driver was a young Indian man who migrated (originally) to Sydney (then to Melbourne) with $1,500 to his name. He’s a chef, although, he’s driving Uber until he finds a new job in Melbourne. His wife is a primary school teacher, and he has two young kids. His biggest worry – that his kids won’t value money and the hard work that comes with it.

During my discussions with clients and investors of late, this is a common theme that has recently emerged – generational wealth transfer.

What will my children’s future hold? How do we pass on our values? How can we protect our family’s assets? These are all questions that are being asked by concerned families. While looking into the future is impossible, there are certainly ways we can help our children prepare for it. I think one of the most important aspects of generational wealth transfer is to understand how the attitudes of our children have changed toward family, work, and money.

According to a recent (US) study by UBS, while most Boomers were ‘on their own’ after they finished college, three in four Millennials still receive financial assistance. Rather than viewing their support as a burden, the vast majority (80%) of Boomers feel good about being able to help their children. Only 10% of Boomers withhold support to teach their children financial independence.

Here’s a true story

It was January 4, 1877 and the world’s richest man had just died. Cornelius “The Commodore” Vanderbilt had amassed a fortune of over $100 million over the course of his lifetime as a railroad/transportation pioneer. The Commodore was of the belief that splitting the family fortune would lead to ruin, so he left a majority of his wealth ($95 million) to his son William H. Vanderbilt. At the time of this bequest, $95 million was more money than was held in the entire U.S. Treasury.

The Commodore’s decision not to split his empire proved right. Over the next 9 years, William H. doubled his father’s fortune to nearly $200 million through proper management of the railroad business. After adjusting for inflation, the $200 million Vanderbilt fortune would be worth roughly $5 billion in 2017 dollars.

However, William H.’s death in late 1885 would cultivate the seeds of folly that would lead to the fall of House Vanderbilt. Within 20 years no Vanderbilt would be among the richest people in America, and when 120 of the Commodore’s descendants gathered at Vanderbilt University in 1973 for the first family reunion, there was not a millionaire among them.

This is the story told in ‘Fortune’s Children: The Fall of House Vanderbilt’. Before I finish this story, I want to highlight a saying popularized by the great Charlie Munger, Warren Buffett’s long time business partner:

Invert, always invert.

Originally formulated by the German mathematician Carl Jacobi, the idea was to solve a problem backwards rather than forwards. So rather than asking, “What’s the best way to keep wealth?”, we should ask ourselves, “What’s the best way to lose wealth?” In the Vanderbilt story we have our answer. So without further ado, I present a step-by-step guide on how to lose a fortune:

Spend money like no one else

Have you ever:

  • Dined while on horseback?
  • Owned 9 mansions on Fifth Avenue (some of the most expensive real estate in New York City)?
  • Thrown a party that cost $5 million?
  • Sunk your yacht and then immediately ordered a larger yacht in order to not upset your wife?

These are just a few examples of the Vanderbilts’ spending decisions during the infamous Gilded Age in American history. Extravagance was all the rage during this period and much of it had to do with the vast amounts of wealth created and owned by a small section of society. It has been estimated that before the Civil War (1860s) there were less than a dozen millionaires in the United States, but by 1892 there were over 4,000! New York City was at the heart of this age of opulence, and the Vanderbilts were center stage for much of this time.

As I read the Vanderbilt story it dawned on me that spending money isn’t enough to lose a great fortune. You have to spend money like no one else. The grandchildren and great-grandchildren of the Commodore were no exception to this rule.

Sell your assets at the worst possible time

You may be asking yourself, “How could the Vanderbilts ever become poor? Couldn’t they just sell their mansions?” Your logic is right, but your timing is wrong. They did sell their mansions and many of their other assets, but at some of the worst possible times.

One of the clearest examples of this was the Vanderbilt vacation home known as Marble House in Newport, Rhode Island. Marble House cost $11 million to build in 1892, which is equivalent to roughly $285 million in 2017 dollars:

However, during the heart of the Great Depression in 1932, Marble House was sold for a price of $100,000, or less than 1% of its price to build! A similar fate befell William H. Vanderbilt’s collection of 183 paintings when they were sold in 1945:

“The very best foreign paintings that money could buy,” which he had purchased for more than $2 million — were sold during the evenings of April 18 and 19, 1945 for a total of $323,195.

The fact remains that if you are forced to sell assets in a market with a few number of buyers, you will take large haircuts. This is especially true in markets for luxury items and other esoteric assets (i.e. art, wine, etc.). Here’s how those assets have performed relative to the world stock market since 1900 (click for larger image):

So, how do you prevent this from happening to you? Have ample liquidity (i.e. cash reserves) so that you aren’t forced to sell assets during market turbulence and drawdowns. If you need to spend money and you can’t, that’s risk. Why? There is nothing worse for an investor than selling an asset at rock bottom prices in order to get cash for essential purchases. If it can happen to the Vanderbilts, it can happen to you.

Never buy an income producing asset

Of all the financial sins committed by House Vanderbilt, this one is probably the worst. During their entire fall from grace there is no account of a Vanderbilt purchasing an income producing asset. This is one of the biggest differences between those who grow wealthy and those who don’t — the wealthy buy income producing assets.

While it is true that the Vanderbilts all owned parts of their railroad empire, they never diversified or expanded their holdings, and their wealth slowly faded away as a result.

You Only Need to Get Rich Once

In the financial ashes of the House Vanderbilt we can learn many great lessons. You only need one big break (or many small breaks) to get wealthy. Once you get there, let the words of the late Commodore guide you:

Any fool can make a fortune. It takes a man of brains to hold onto it after it is made.

– Cornelius “The Commodore” Vanderbilt

Let me leave you with a quote from the book, Fortune’s Children, which perfectly illustrates the Commodore’s relationship with his son:

Today, this relationship is very different. Here’s the latest from UBS’ research:

I guess everyone has a very different way of educating their children about money and finances. However you decide to preserve your hard work and wealth, whether and how you choose to distill your values into your children are all personal choices.

Whether you’re driving Uber between jobs and raising two young children, to multi-million dollar businesses and balance sheets with grown children and fiancés, it’s a growing concern that needs to be addressed. Get the conversation going.

This story was originally posted by Nick Maggiullu – Of Dollars & Data with some personal editing.

How to Invest Your Money

Over the last week, I’ve been speaking with a number of clients and investors about their investment portfolios and how to best allocate capital.

It’s a tough one. With so much content being publish dictating how we should invest our money, it’s no surprise investors are being left a little confused. I feel as though many investors are allocating capital based on how someone else thinks they should live their life, rather than allocating capital based on their own life goals and priorities. I mean, who better to tell us what we want than ourselves, right?

So, I decided to create a blueprint to help you decide how to allocate your capital, with the following caveat: There are many other investment options that are available to investors than what has been captured in this design, although, I reckon you could probably place most of them in each of the buckets I have included. My point is, it’s not perfect, but a good enough guide.

If you have any questions, need clarification, or would like to discuss further, please feel free to get in touch.

Enjoy (click for larger image).

Like any destination, before you decide how you’re going to get there, it makes sense to decide on where you’re going first.

The Market Collapse Explained

Over the last week, I’ve been speaking with a number of people about what’s been going on in financial markets. People that typically don’t follow the financial markets seem to have knowledge of it’s collapse. But what really happened and why? Here’s my attempt of a simple explanation of what’s been happening and why.

Here’s the last week or so in trading:

We haven’t seen this much market volatility for a long time. Here’s market volatility, a measure of market risk, or what is also known as the “fear index”, since 2008.

Source: MarketWatch

We have not seen market volatility like we are seeing today, since 2011. Investors have been accustom to market calm for 7 years – 7 years, without a bump, and you wonder why everyone is freaking out. Having said this, the level of market risk we are witnessing now is nowhere near the levels we saw in the 2008-2011 period.

So what happened?

On Friday (02/02), the US released employment data that showed not only were more jobs being created, but wages were growing faster than expected. Higher wages means inflation. And too much inflation may prompt central banks, in this case the US Federal Reserve, to raise interest rates. This has investors worried about the implications of higher rates on stocks and bonds.

Why does this matter?

Inflation has a kind of insidious effect. The cost of production rises, company revenues fall as they try and adsorb the early stage rises, and the economy starts to slow until consumers become accustom to a new pricing environment. This can be bad for stocks.

High inflation can be a good thing, as it can stimulate job growth. However, it could also impact corporate profits if company’s are unable to pass on the higher input costs to consumers.

What’s interesting is that since the GFC, we have seen corporations passing on higher input costs not via increased prices, rather, reducing the size of their products, also known as ‘shrinkflation‘.

Investors are also less likely to hold cash during times of inflation, because it’s value decreases over time. It can be a confusing time for investors. It can also be challenging for central banks as they want to ensure some inflation, but not too much.

The last week as has both the bond market and stock market sell of at the same time. This doesn’t happen too often, but it does happen, as I wrote about last week.

What’s the impact on my bonds

Let’s say you purchased a government bond for $100. This bond is paying you 2.50% pa. You’re happy. You can buy more of these bonds, or in fact sell your bond…for $100 (as long as someone is willing to pay you $100).

As inflation rises, so to follow interest rates. Some time passes since you purchased your government bond. The government announces it’s issuing a new bond. It’s worth $100, but they’re now paying 2.75% pa.

Now, if you had a choice of buying two bonds, both worth $100, but one paying 2.50% and the other 2.75% pa., which bond would you buy (not a trick question)? The one paying 2.75% of course. What this means is that if an investor has this choice, they’re not going to be paying you $100 for your bond paying 2.50%. They may offer you $95 for your bond however. And there it is. What investors fear. Loss.

Yes, your the price of your bond can go down (and up too, if rates fall, as we have been seeing over the last decade and more).

However, as long as you hold your bond until it’s maturity, you’l receive you $100 back. Whats more, is that you may be able to buy bonds that are selling at a discount to their issue price as rates rise. And as these bonds get closer to their respective maturity dates, the prices rises, and voilà – capital gain!

A history lesson in stocks

You’d be forgiven for blowing the dust off the history books in an attempt to examine the impact of high inflation and stocks. There have been numerous studies that have looked at the impact of inflation on stock returns. Unfortunately however, the studies have produced conflicting results. Here are some numbers I analysed courtesy of Robert Shiller’s data, which shows us how the stock market has performed given different levels of inflation. The x-axis (horizontal) represents the inflation rate, and the y-axis (vertical) represents the corresponding return in the stock market during that year.

As you can see, trying to find a pattern in the data is very difficult.

 

Source: Robert Shiller data

Let’s take a look at things a little differently.

In the following chart we can see the blue bars represent the average annual inflation for each year during the decade. So we can see for instance that in the years between 1913 and the end of 1919 they averaged 9.8% inflation. That is a high annual inflation rate! The stock market on the other hand generated just over 5% (5.68% to be exact). In the 1920’s, the annual inflation rate was virtually non-existent (actually slightly deflationary at less than 1/10th percent deflation) and the stock market soared. In the 1930’s the stock market had a bad decade and basically finished where it started (after dropping like a rock). So from this chart you can see that there doesn’t appear to be a correlation between high inflation and high stock market returns. If anything there might be an inverse correlation with the stock market doing better during decades when the inflation rate is below 3%. With the exceptions being the 1930’s when there was outright deflation and the 2000’s.

 

The market is worried that the Federal Reserve will have to raise rates much quicker than anticipated, given the surprising data. Here’s why it makes a difference. Bloomberg put together this great chart, which plots the performance of the US stock market during slow tightening cycles (raising rates slowly), and fast tightening cycles (raising rates quickly). And as you can see in the chart below, the performance of the stock market during the two cycles follow a similar path.

Bringing it all together

Since the GFC, interest rates around the world have hit rock bottom. Central banks around the world have been working hard to try and resuscitate a dying economy. Investors seem to have turned a blind eye to the reality of the global economy as they ploughed money into risky assets, such as shares and property – sending the price of risky assets around the world to record highs.

More and more we’re starting to see signs that the global economy is improving – yet the market would prefer an environment of fragility whilst being supported by the ‘invisible hand’ (governments and central banks).

All we’ve done over the last 7 or so years, is anticipate a stronger economy and have brought forward our future gains. Investors need to understand that periods of high growth are followed by periods of low growth, and vice versa. There is nothing new here, yet you’ll be told it’s a “new era”, and that we’ve never seen anything like this before. You’ll hear the saying, “time will tell”, more than you ever have, because no one knows how this is going to play out – don’t be fooled by somebody else’s ignorance. The outcome is not binary. Market’s may continue to rise for sometime, they may meander along, or we may have just seen the beginning of what’s to come.

What is certain however, is that the time will come when rates rise, whether faster or slower than expected. This will be because the economy is heating up. Heating up too quickly for the liking of central banks. And eventually, we will see a real collapse in the price of risky assets, including stocks and property. Like always, it will be temporary, although the market will respond as if it is permanent.

Plan ahead, and pack for your destination, not somebody else’s.

The Crash Begins. And There’s Nowhere to Hide.

The day has come my friends. A dip…finally. Or as some are calling it…a market crash.

Over the weekend, the US stock-market tumbled 666 points in the biggest fall since June 2016. In fact, it’s the 531st worst day in the history of the Dow Jones Industrial Average – we’ve seen this before.

What we haven’t seen before however, is the stock market trading 310 days without back to back 0.50% declines. Let that sink in for a moment. We need to go back to November 2, 2016, since we’ve had two days in a row of declines of just half a percent.

Source: BIG

Given we haven’t seen a meaningful pullback for some time, the current decline is going to feel extremely painful for some investors. And for investors who haven’t witnessed these types of declines, not pressing the sell button is going to be a little difficult, which in turn could make things a little worse.

The stock-market is a giant distraction to the business of investing. Invest for the long term, and pay no attention to the foolishness that goes on in the short term in the stock market.

– Jack Bogle

To put Friday into perspective, it marked the seventeenth -2% day for the S&P500 in the last five years. An average of 3.4 times per year.

 

Source: Michael Batnick

The funny thing is though, when the stock market rises for such a long period, we’re telling everyone a pullback is due. And when it finally arrives, everyone freaks out. Here’s market volatility, also known as the ‘fear index’, climbing it’s way higher after claiming record lows in November 2017.

One of the other reasons the market is freaking out is because both bonds and stocks fell at the same time, something that isn’t supposed to happen…apparently.

Bonds are supposed to provide your portfolio with support when stocks are losing money, as they’re supposed to act as a diversifier. But what is supposed to happen to stocks when bonds lose money? Can stocks diversify your portfolio from bonds? Ben Carlson of A Wealth of Common Sense ran the numbers a little while ago, however I decided to look into it myself. I’ve crunched the numbers, and here’s what I’ve found.

I’ve taken the S&P500 and Five-Year US Treasury data going back to 1926 and adjusted it for inflation. First, I looked at how bonds performed when the stock market was down:

Date S&P500 Five-Year US Treasury
Jan-30 -13.80% 5.88%
Jan-31 -32.26% 13.42%
Jan-32 -45.58% 8.13%
Jan-33 -13.81% 18.78%
Jan-35 -23.44% 5.80%
Jan-38 -39.25% 2.03%
Jan-40 -0.89% 4.79%
Jan-41 -14.08% 1.68%
Jan-42 -7.02% -10.12%
Jan-47 -12.85% -17.29%
Jan-48 -1.67% -9.40%
Jan-58 -8.62% 2.07%
Jan-63 -6.21% 4.41%
Jan-67 -9.37% 2.44%
Jan-70 -13.42% -7.47%
Jan-71 -1.38% 13.18%
Jan-74 -18.79% -4.63%
Jan-75 -22.71% -5.65%
Jan-77 -4.92% 4.89%
Jan-78 -11.72% -3.34%
Jan-82 -11.82% 1.26%
Jan-83 -0.83% 24.84%
Jan-88 -8.30% 0.98%
Jan-91 -3.68% 6.42%
Jan-93 -1.70% 9.02%
Jan-01 -15.21% 10.58%
Jan-02 -23.10% 5.81%
Jan-03 -34.55% 8.94%
Jan-08 -15.48% 8.89%
Jan-09 -47.04% 8.38%
Jan-12 -4.01% 5.30%
Jan-16 -2.38% 0.34%
Average -14.68% 3.76%

Then I looked at how the stock-market performed when bonds were down:

Date S&P500 Five-Year US Treasury
Jan-42 -7.02% -10.12%
Jan-43 25.57% -6.06%
Jan-44 16.75% -0.44%
Jan-45 17.36% -0.08%
Jan-46 41.79% -0.16%
Jan-47 -12.85% -17.29%
Jan-48 -1.67% -9.40%
Jan-51 36.45% -7.11%
Jan-52 18.18% -3.81%
Jan-57 5.08% -2.10%
Jan-59 39.74% -3.15%
Jan-66 8.76% -1.30%
Jan-68 8.67% -2.37%
Jan-69 11.30% -0.47%
Jan-70 -13.42% -7.47%
Jan-74 -18.79% -4.63%
Jan-75 -22.71% -5.65%
Jan-78 -11.72% -3.34%
Jan-79 14.18% -5.36%
Jan-80 18.44% -11.78%
Jan-81 13.67% -6.16%
Jan-89 16.02% -0.56%
Jan-95 5.26% -7.54%
Jan-97 24.05% -0.75%
Jan-00 13.18% -5.57%
Jan-05 4.23% -0.97%
Jan-06 9.65% -3.25%
Jan-10 32.00% -1.49%
Jan-13 15.83% -0.64%
Jan-14 23.33% -3.40%
Jan-17 20.00% -2.46%
Average 11.33% -4.35%

Here’s all the data and the take out:

Date S&P500 Five-Year US Treasury
Jan-27 4.20% 7.49%
Jan-28 35.21% 5.56%
Jan-29 52.42% 1.33%
Jan-30 -13.80% 5.88%
Jan-31 -32.26% 13.42%
Jan-32 -45.58% 8.13%
Jan-33 -13.81% 18.78%
Jan-34 65.65% 0.98%
Jan-35 -23.44% 5.80%
Jan-36 58.54% 4.29%
Jan-37 27.64% 0.60%
Jan-38 -39.25% 2.03%
Jan-39 14.83% 7.05%
Jan-40 -0.89% 4.79%
Jan-41 -14.08% 1.68%
Jan-42 -7.02% -10.12%
Jan-43 25.57% -6.06%
Jan-44 16.75% -0.44%
Jan-45 17.36% -0.08%
Jan-46 41.79% -0.16%
Jan-47 -12.85% -17.29%
Jan-48 -1.67% -9.40%
Jan-49 8.11% 0.72%
Jan-50 18.67% 4.07%
Jan-51 36.45% -7.11%
Jan-52 18.18% -3.81%
Jan-53 14.45% 0.85%
Jan-54 0.92% 2.80%
Jan-55 46.01% 2.44%
Jan-56 23.81% 0.34%
Jan-57 5.08% -2.10%
Jan-58 -8.62% 2.07%
Jan-59 39.74% -3.15%
Jan-60 2.31% 0.25%
Jan-61 5.59% 7.70%
Jan-62 12.84% 1.32%
Jan-63 -6.21% 4.41%
Jan-64 17.90% 0.63%
Jan-65 13.07% 3.17%
Jan-66 8.76% -1.30%
Jan-67 -9.37% 2.44%
Jan-68 8.67% -2.37%
Jan-69 11.30% -0.47%
Jan-70 -13.42% -7.47%
Jan-71 -1.38% 13.18%
Jan-72 3.80% 4.78%
Jan-73 10.86% 0.35%
Jan-74 -18.79% -4.63%
Jan-75 -22.71% -5.65%
Jan-76 28.71% 1.15%
Jan-77 -4.92% 4.89%
Jan-78 -11.72% -3.34%
Jan-79 14.18% -5.36%
Jan-80 18.44% -11.78%
Jan-81 13.67% -6.16%
Jan-82 -11.82% 1.26%
Jan-83 -0.83% 24.84%
Jan-84 8.39% 5.04%
Jan-85 0.84% 10.81%
Jan-86 4.41% 14.99%
Jan-87 18.38% 13.96%
Jan-88 -8.30% 0.98%
Jan-89 16.02% -0.56%
Jan-90 3.63% 5.56%
Jan-91 -3.68% 6.42%
Jan-92 10.68% 9.42%
Jan-93 -1.70% 9.02%
Jan-94 3.07% 7.28%
Jan-95 5.26% -7.54%
Jan-96 23.88% 12.06%
Jan-97 24.05% -0.75%
Jan-98 16.85% 8.49%
Jan-99 23.64% 7.18%
Jan-00 13.18% -5.57%
Jan-01 -15.21% 10.58%
Jan-02 -23.10% 5.81%
Jan-03 -34.55% 8.94%
Jan-04 30.73% 1.92%
Jan-05 4.23% -0.97%
Jan-06 9.65% -3.25%
Jan-07 11.21% 1.23%
Jan-08 -15.48% 8.89%
Jan-09 -47.04% 8.38%
Jan-10 32.00% -1.49%
Jan-11 16.45% 4.10%
Jan-12 -4.01% 5.30%
Jan-13 15.83% -0.64%
Jan-14 23.33% -3.40%
Jan-15 10.11% 4.21%
Jan-16 -2.38% 0.34%
Jan-17 20.00% -2.46%
Average 6.78% 2.28%

Source: Returns 2.0

Since 1926, the stock market has been down 32 years out of 91, and the bond market has been down 31 times – an average of around 35%, or up around 65% of the time. Of the 31 years that bonds were down, stocks were also down in just 7 of those years – or 22.58% of the time. Put differently, stocks were up >77% of the time bonds were down.

What we have witnessed over the weekend doesn’t happen too often, but it does happen. Stocks diversify bonds and bonds diversify stocks. Most importantly, investors need to ensure the allocation between bonds and stocks in their portfolio is the right mix for them. The allocation to stocks in my portfolio is almost 100%. The allocation to stocks in most of our retired clients’ portfolios is between 50% and 70%. There is no “right” mix for all. Investors must find the right mix for them.