Advisor Voices: Common Destroyers of Wealth
23 April 2019
Common Destroyers of Wealth: Known Knowns, Unknown Knowns and Unknown Unknowns
“There are known knowns. These are the things that we know. There are known unknowns. That is to say there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.” - Donald Rumsfeld
So much of the wealth management industry revolves around the fulfilment of dreams and the establishment of legacies. It is also about understanding the threats to wealth: fixing what we know, diagnosing what we don’t know and then preparing for the unknown. Having spent my career listening, diagnosing and fixing problems for the wealthy, I think there is a major misconception about what destroys wealth.
Many people assume that poor investing or inferior tax planning causes a family’s financial situation to go backward. However, the main wealth destroyers (and the things you should be concerned about) center on four primary pillars; Overspending, Communication & Conflict, Overconcentration and Leverage.
This is a “known unknown” for most families. Overspending is something that many families feel but can’t quantify because they haven’t asked some difficult questions. How much is our current spending costing us? How much will our future spending cost us? Will our spending affect the legacy we leave behind?
These are blunt questions, but important ones to ask. When resources are gone they are extremely difficult to replace.
The road to ruin has been paved with examples of people who have tried to “invest their way” back into a lifestyle brought on by outsized spending and asset-depletion.
A first step in fighting this problem is to go through the exercise of a creating a financial plan: Thinking through values, goals and objectives. Pinning down assets and liabilities. Understanding the difference between net worth and actual liquidity. Finally, establishing what is realistic with future cash flow.
An additional step in conquering the problem of unchecked spending is to assemble a team of trusted confidants and professionals that will help you and your family maintain the discipline of living within your means while achieving your goals.
Communication and Conflict
“I don’t like violence, Tom. I’m a businessman. Blood is a big expense.” -- Character, Victor Sollozzo in “The Godfather”
This famous quote sums up something that within my 20-plus years of working in law and banking, I have come to believe in: Conflict is expensive and painful. Yet another “known unknown”.
Conflict comes in many forms, usually stemming from poor communication between interested parties. The traditional role of the wealth manager is to get “the money ready for the family”. However, the real work tends to come in getting “the family ready for the money.” Why is that? Shouldn’t abundance make things easier? The fact is . . . it doesn’t. Abundance can create a situation whereby problems and issues lurk around every corner, such as:
- Transmitting the values of success to ones’ kids and family members.
- Avoiding the specter of laziness and entitlement in the next generation.
- Promoting an environment where siblings and family members appreciate each-others’ talents and differences.
- Addressing one child’s needs to address their distinct situation while treating other children “fairly”
For families whose wealth is tied to a business, the selling or transitioning of that business should recognize the personal investment and goals of its founder and/or current owner, as well as respect the needs of the future owners, managers, customers, vendors and other constituents. This situation, of course, can be wrought with conflict when multiple parties and/or beneficiaries are involved. However, thoughtful and purposeful communication can go a long way in helping to mitigate related concerns.
It’s imperative to include a spouse and all affected family members into a discussion around the family wealth plan. This is especially true during times of change to wealth, the law, or the family itself, such as divorce or a lawsuit. The family’s first wealth-centered discussion should not occur at a point when a family member dies.
Avoiding communication creates an “unknown unknown”, a scenario where basic information doesn’t get to the decision-makers in a relationship. Communication is the best way to defend against these “unknowns” and those problems that come up that we could not anticipate. Staying silent and relying solely on the technical merits of a wealth plan nearly guarantees conflict. This leads to disharmony, bruised feelings and, sometimes, litigation.
Resolving those issues can be, as Victor Sollozzo put it, “. . . a big expense.”
One of the saddest and most avoidable destroyers of wealth revolves around overconcentration. “Don’t put all of your eggs into one basket” is an adage recognized for generations around the world. However, some people DID put their eggs in one basket when building their wealth. They recognized an advantage, took a risk, made a big bet and it paid off handsomely. That same concept doesn’t translate well for many people after that success. The ability for the original source for wealth to continue generating is a known unknown.
Lehman Brothers, AIG, Kodak, Polaroid, . . . these are some of the many examples of once-great companies that didn’t last due, in part, to a singular and habitual focus on a core business or business model.
In families, when loyalty to tradition becomes an emotional decision, disaster can loom. I believe that Diversification can be a great protector of wealth; a great tool to address this known unknown, and an important component in strategic wealth plan.
“When you combine ignorance and leverage, you get some pretty interesting results.” --Warren Buffett
No one is immune from the laws of leverage. Leverage in the investment world is the borrowing of money to fund a venture or amplify one’s return. It can apply to a mortgage that allows one to buy a larger house. It can be a student loan which represents an investment in one’s future earning power. Or, someone can borrow money to make other investments.
Most insidiously, leverage can support lifestyle-spending. The problem is that the bill inevitably comes due. People or institutions that lend money want to be paid back. If the house is under water, the assets’ value collapses, sources of cash flow stop, or the money has been spent, the lender will seek repayment with whatever there is left that has value.
Leverage magnifies results and emphasizes mistakes. When used recklessly or left unchecked, leverage can cause bankruptcies. It is vital that families understand the role of leverage in the balance sheet and take the steps with their advisors in managing their debt.
Two Other Factors
Of course, a discussion on wealth destroyers wouldn’t be complete without touching on what many believe to be the primary destroyers of wealth: poor or insufficient investing and tax planning. While these factors can contribute to many fortunes’ demise, most successful people surround themselves with excellent advisors on the wealth and tax front. With the inclusion of professional advisors, these individuals turn a “known unknown” into a “known known.” In other words, when they realize that they don’t know what they don’t know, they hire professionals who take responsibility to know for them.
By taking the time, along with your advisory team –-to become aware of spending, open communication, diversification and understand the power of leverage – in my opinion, you stand a better chance of fulfilling your goals and securing for legacy for generations to come.
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Diversification strategies do not ensure a profit and do not protect against losses in declining markets.