In my last two posts (scroll down) I first set up the situation: the fourth generation of the Smith family had got a great price for the family business, albeit not without a lot of bruised feelings, and now had, net, $250 million in cash. In the second post I described how the Smiths promptly lost almost half the fortune in the 2008-09 market debacle, and how, in the process, they had lost something even more precious: the happiness of their family.
Most disturbingly, I suggested that all this had to happen the way it happened. Generally speaking, long-owned family companies only get sold near the top of Bull Markets. And generally speaking, those families invest their fortunes immediately. All else follows as night follows day: the markets collapse; the family loses a major chunk of its fortune in a few months; the family bails out of the markets in a panic and misses the recovery; family members blame each other for the debacle, often in court. Result, as Mr. Micawber would say, misery.(1)
This outcome, which occurs over and over again at every market peak (note that we’re near one now), is a terrible tragedy for the families involved. But, as I’ve written about many times in many places, it’s also a tragedy for the United States of America. Liquid private capital in the hands of the post-liquidity-event generations is America’s secret weapon in its competition against other nations, and is at the very root of American Exceptionalism.(2)
Rather than compound tragedy upon tragedy, is there some way families can avoid the fate of the Smiths? The answer, I’m afraid, is yes and no. Yes, in the sense that a disciplined investment program can almost always avoid the loss of the capital (see below). No, in the sense that launching and sticking to such a disciplined investment program is impossible for most families.
How Not to Lose a Fortune
The best way not to lose a fortune your family has spent generations building is to internalize the simple truth that, if you just sold your family business for a really good price, the markets are about to crash. If that’s true – if it’s even a realistic possibility out there on the horizon – then it’s incredibly bad timing to invest the entire fortune right away.
In fact, if we move from the Micawber Principle to the Curtis Principle, we find this nugget: When a long-owned family business is sold, the proceeds should almost always be invested over not less than one complete market cycle. In the case of the Smiths, the fortune had been built gradually over the course of more than a century. Even if the date of the sale of the family company had been entirely random, what sense would it make to dump the entire proceeds into the market immediately? The risks associated with owning a long-held family business are wholly different from – almost unrelated to – the risks of investing in the stock market. The skill set is different, the mindset is different, the experiential disadvantages are huge, behavioral mistakes are devilishly difficult to avoid, conflicts of interest are everywhere.
If this is the case, what sense did it make for the Smiths to invest their money aggressively? Why did the Smiths, who are certainly not stupid, do it?
They did it because they didn’t view themselves as aggressive investors – even though they were, in fact, playing recklessly with capital that was a century old. The Smiths were behaving like a retail investor who saw the markets going up every day and wanted to be part of it. It didn’t occur to them that they were now living in a very different world and managing a very different kind of business. They were now in the business of preserving their liquid capital, of stewarding it for the next generation, which would steward it in their turn. To paraphrase the famous watch commercial, “You don’t own a liquid fortune, you only take care of it for the next generation.”(3)
What the Smiths should have done is to say to themselves something like this:
“Ok, we’re living in a different world now and we owe it to the hard-working generations that went before us and to the generations coming along behind us to keep this capital intact. In fact, we owe it to America, which allowed us to become so successful, to maintain and deploy our capital in ways that will keep the country strong. Sure, it’s an exciting time in the stock markets, but we’re already rich – we just need to avoid getting poor and/or breaking up our family.”
With this mindset, the Smiths would have dribbled their capital slowly into the markets over a period of five-to-seven years – five if the markets were reasonably valued at the date of the sale (highly unlikely), seven if the markets seemed over-valued. If the Smiths had done this they would have been wealthier today than they were at the closing back in 2007, despite the market debacle of 2008-early 2009. Their family and their personal happiness would be intact.
Unfortunately, most post-liquidity families will follow the actual Smith model: they won’t be able to resist jumping into the Bull Market. The reasons are the ones I posited in my last post: everyone in the family wants to avoid being left behind by a Bull Market; the financial advisor wants to get paid; no one is thinking about how special this capital is.(4)
As a fallback, I offer the following reluctant modification to the Curtis Principle, vastly expanded but possibly easier to swallow, namely: When a long-owned family business is sold, even if you (foolishly) don’t think the markets are about to crash, the proceeds should almost always be invested according to the Curtis Principle, Corollary 1:
- If the trailing twelve-month PE of the S&P 500 is between 12X and 18X, the proceeds should be invested monthly over a five-year period.
- If the trailing twelve-month PE of the S&P 500 is over 18X, the proceeds should be invested monthly over a seven-year period.
- If the trailing twelve-month PE of the S&P 500 is under 12X, the proceeds should be invested monthly over a three-year period.
Finally, don’t forget Corollary 2: Never, ever, bail out of a Bear Market, no matter how bad it seems. Your capital is permanent capital and you should be thinking dynastically, not tactically. Your enemy isn’t market volatility, not even extreme volatility. Your enemy is the social and political collapse of your home society, what William Bernstein calls “deep risk.”(5) And by preserving your family’s capital indefinitely and investing it wisely, you are yourselves helping to stave off that kind of calamity.
(1) The Micawber Principle: “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.” Dickens, David Copperfield.
(2) Creative Capital (2004); The Stewardship of Wealth (2013); blog posts of 4/19/13 through 6/7/13.
(3) “You never actually own a Patek Philippe. You merely take care of it for the next generation.”
(4) It’s hard to express how rare it is for families to build very large fortunes. When people bandy about the term “the 1%,” they are talking about a vastly less wealthy group. Here we are talking about, perhaps, “the 1/1000th of 1%.”
(5) Deep Risk: How History Informs Portfolio Design (Investing For Adults) (Volume 3). Deep risk includes the possibility of confiscation of family assets even without a broader social collapse, as happened recently in France when Mitterrand nationalized the Rothschild Bank.
Next up: Replaced by a Machine, Part 1
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.