Preface

Nothing corrupts a man so deeply as writing a book.

—Nero Wolfe¹

Over the years, thousands of investment books have been written. A precious few have become classics in the field, but the rest are long, and probably best, forgotten. Given this ponderous history, even the author himself must wonder whether he may be trying the patience of the reading public with yet another book on investing.

I plead this: I'm approaching the investment challenge from a different perspective than most—indeed, than virtually all—of my predecessors. In the first place, I'm addressing a very special audience—wealthy investors and their advisors. In the second place, the purpose of most investment books is to make us better investors. But this book has a slightly but importantly different objective: to help significant investors to become better stewards of their assets, whether or not they ever become good investors in the professional sense of the word.

Finally, this book, and especially Part One, constitutes a cri de coeur for the importance of private capital in the American free market economy—something too many people, including too many wealthy people, fail to understand. The so-called 1 percent—that group of people whose wealth or earnings place them above 99 percent of the rest of the population—has become a whipping boy for everything that is wrong with America.

There is certainly a lot wrong with America, and some of it involves the 1 percent. But in fact the top quartile of American society is as competitive as it has ever been—perhaps even more so. The bottom continues to struggle, as it always has, and needs help. What is new is that the middle—the great American middle class—is now struggling as it has never done before.

Much of what ails the middle class has to do with the globalization of competition—Americans who used to compete only with other Americans now must compete with Chinese, Indians, Brazilians, and so on, many of whom are far more cost competitive. But some of it is self-inflicted: The American middle class isn't prepared, educationally or by temperament, for the cutthroat world it now occupies. American public policy needs to focus on this issue, but speaking very broadly, if the middle class wants to regain its competitiveness globally, it could do a lot worse than to emulate the path taken by the 1 percent.²

Investors versus Stewards

As noted later in this preface, good stewardship involves much more than investing capital soundly. It involves the ongoing growth and nourishment of a family's human capital in the broadest sense. And it involves the recognition that the responsible management and creative use of private wealth is crucial to the continued vitality of the American free market democracy. Families and their advisors need to view the challenge of stewardship in this broader sense.

What is the difference between being a good investor and being a good steward of wealth? In the first place, stewardship is a much broader issue. It has to do with all the things that will bear on the long-term success of the family.³ Investing has to do with one particular issue—the management of private capital. Although that issue is central to the question of stewardship, and is the main subject of this book, investing is only a part of the broader challenge. Indeed, it isn't necessary for every member of a wealthy family—or any members, for that matter—to become professional investors.

What is necessary is that members of the family—preferably all of them—gain enough of an understanding of the investment process and the capital markets to enable the family to be an astute consumer of investment services. There are many talented financial advisors out there, but there are also many—indeed, many more—who don't have a clue. At the very least, a wealthy family needs to know enough to select a good advisor and to monitor that advisor's performance.

This requires a certain amount of hard work, but it stops short of requiring that family members become investment professionals themselves. Most important, it requires that the family develop ways of working together, ways of sharing information, ways to make cohesive and intelligent and timely decisions about assets that may be widely scattered in many different family “pockets.”

It's possible that the wealthiest senior generations of families can live a perfectly happy life without paying the slightest attention to the issue of stewardship. It's even possible, though far less likely, that their children won't have their lives and their happiness disrupted when they suddenly inherit large sums of money they are ill-prepared to deal with. The great probability, however, is that instead of contributing to the happiness of such families and to the betterment of the world they live in, families that ignore their stewardship obligations are probably headed for a train wreck. Money can be a great force for good, but it can also corrupt and destroy a family.

The whole point of stewardship is to avoid this train wreck. Having wealth brings with it serious responsibilities, for two reasons. The first, as noted, is that money has the power to destroy lives. We don't behave irresponsibly around dynamite or loaded pistols, and we should never behave irresponsibly around millions of dollars.

The second reason is that private capital plays a crucial role in the way America has chosen to organize its society and its economy. Failure of stewardship by a wealthy family is a very large failure, an act of irresponsibility by the very people who have been most favored by the American economic system.

Most of this book is an attempt to help wealthy families discharge their stewardship obligations more effectively. But it is also important for the wealthy—and for the nonwealthy—to understand just how crucial a matter it is that private capital be properly managed. That important point is the subject of Part One of this book.

Best Investment Practices

Anna Karenina famously begins with Tolstoy's remark that, “All happy families are alike; every unhappy family is unhappy in its own way.” Whether or not Tolstoy was right about families and happiness in general, his idea certainly applies to families as investors.

All “happy” families—that is, those who are able to preserve and grow their wealth across the generations—are very much alike in the sense that they follow what I refer to in this book as best investment practices. These are practices that have demonstrated their worth in the portfolios of the world's largest and most sophisticated investors over many decades. It is a principal purpose of this book to identify best practices for taxable investors, to explain why they are important, and to show family investors how best to employ them in their own investment portfolios.

It's also the case that “unhappy” families—those whose wealth disappears—tend to be unhappy in their own ways. While there is only one certain way to preserve wealth—namely, to take stewardship very seriously—there are many, many ways to destroy wealth. Some of these tend to occur slowly over time: Poor strategies and managers and unnecessary investment costs and taxes act like portfolio cancers, slowly destroying wealth over the years. Other bad practices destroy wealth quickly, as the result of one spectacularly bad decision.

Complex Markets

Most of us will never be forced to deal with a system more complex than the capital markets. No one completely understands how markets work or why they behave the way they do. No one can anticipate when markets will go up or down or how much they will move. Markets encompass all the complexity of the human beings who deal in and with them, as well as all the complexity of any system that is made up of millions of moving parts, some of which are related to each other and some of which aren't. And ultimately, of course, all this complexity is at the mercy of technically unrelated matters, such as the stability and vigor of the societies that provide the structures and mores through which capital markets must operate.

Thus, attempts to understand how markets work must inquire into modern portfolio theory (which builds models that, at least over long periods of time, tend to describe the operation of markets); behavioral finance (which attempts to describe how human beings respond in the face of investment decisions and market events); law (which governs the legal properties and enforceability of financial instruments); economics (which attempts to explain how economies function); chaos theory (which attempts to describe the behavior of incredibly complex systems); and so on.

On top of this complexity is the issue of the costs associated with managing private capital. No one in the financial industry works for free, and most charge not what is fair in relation to the value they bring, but rather what the market will bear. Consider that as investors we face high money management fees, the round-trip costs of brokerage commissions, the spread between bid and ask prices, the cost of market impact, variance drain,⁴ and opportunity costs (price movement that occurs between the time we decide to act and the time our transaction is executed). Our wealth will be further diminished by inflation, taxes, and spending. Finally, given the complexity of the capital markets, our wealth will also be diminished by the impact of the inevitable investment mistakes we make.

A Complex Industry

No one who takes an honest look at the modern financial services industry can reach any conclusion other than that it is operated in ways that are mainly hostile to the interests of investors. Most firms, for example, are organized in a manner that presents serious and ongoing conflicts of interest with their own clients. And many firms cheerfully hire large numbers of inexperienced professionals who are superb at selling investment products but who understand virtually nothing about the successful management of capital—a good working definition of hostility to the clients' interests. Finally, like any industry, the financial services business has its fair share of crooks, swindlers, con men (and women), and others for whom the term “venal” fits quite nicely.

I am as critical of the industry as anyone—indeed, I have devoted a great deal of text in this book to criticisms of the industry (see Chapter 4). But let's be realistic. All firms—not just financial firms—are in business to make money. The main reason the industry gets away with its deplorable practices is that we are lousy clients. Alongside the rotten firms and callous individuals there are also many superb advisory firms and many, many honest, hard-working financial professionals. Good clients easily gravitate to these people. Moreover, even imperfect advisors can be managed by well-informed clients to minimize damage to their portfolios and maximize the value the advisor is bringing to the relationship.

Yes, the financial industry badly needs to be reformed, and the fact that most of the regulators have long been asleep at the switch—or flat-out owned by the industry—is discouraging, indeed. But investors needn't wait for the regulators to wake up. By educating ourselves about the industry and the investment process, we can go a long way toward avoiding the worst the financial services industry has to offer and to create, instead, fertile partnerships with the many honest, competent advisors available to us.

Complex Societies

Wealthy investors everywhere live in societies that are often hostile, and that are always indifferent, to their attempts to preserve and grow their wealth. In a way, this seems an odd circumstance.

Consider that few would deny the importance not just to the investors themselves, but to society generally, of the sound management of the portfolios of middle-income investors, pension plans, charitable endowments, and foundations. If middle-income investors mismanage their money (especially, but not exclusively, their 401(k) plans), they face an impoverished old age, an outcome that has profound social, political, and economic consequences. If corporate and public pension plans mismanage their portfolios, either taxpayers will have to bail them out (via the Pension Benefit Guaranty Corporation), or higher contributions to the plans will reduce available spending for new jobs and capital equipment, with the consequent impact on economic growth. If endowments and foundations mismanage their portfolios, a society that relies heavily on private philanthropy, rather than government funding, will find funding for services, amenities, and creative new ideas slashed.

In the special case where family wealth takes the form of control of an important corporate enterprise, no one would argue that mismanagement of the enterprise is a matter of no consequence. Most businesses in America are privately held, and some of them are spectacularly large. Privately held Cargill, Inc., headquartered outside Minneapolis, was founded in 1865, boasts annual revenues of $120 billion, and employs 142,000 people in 66 countries. Mismanagement of this form of private capital would have momentous consequences, indeed.

Yet, when it comes to the management of the passive investment portfolios of the wealthy, hostility and indifference set in. Some of this is, to be sure, nothing more than envy, or, when private capital blows up, schadenfreude. But it is more than that—it signifies a profound ignorance of the importance of private capital to American society.

Private Capital and Free Market Democracies

The serious opportunity to get seriously rich is what distinguishes America from most other free market democracies, and it has made America the most dominant civilization in the history of the world. If simply having an essentially free market were all that was required for economic domination, France and Sweden would be powerhouses. But France and Sweden are a pale version of the American free market for the simple reason that getting rich is discouraged in those countries, and being rich is despised. In America, entrepreneurs are heroes, but in much of Europe entrepreneurs are viewed more like dangerous cranks who are simply trying to make everyone else look bad.

Indeed, even cases that appear at first glance to represent the very worst aspects of American-style capitalism often prove to be quite different under more thoughtful analysis. During the Republican Party primary season in 2012, for example, even conservative Republicans savaged Mitt Romney for his private equity activities. The complaint was that private equity buyers sometimes closed firms and laid off people. Certainly if the net result of private equity activity was a reduction in the strength of the economy, that would have been a legitimate criticism.

But capitalism isn't about preserving jobs—it's about preserving good jobs and creating more good jobs. When enterprises are uncompetitive, it's very important—and a critical aspect of capitalism—that those enterprises be pruned before they drag down the entire economy. The evidence in countries like Greece, Italy, and France, where industry after uncompetitive industry is protected, should be decisive.

No one likes it when companies are shuttered and jobs eliminated. But matters would be much worse if we stuck our heads in the sand and kept weak companies on life support. Private equity is at the very heart of capitalism, because private equity firms are looking hard at enterprises that are currently operating at far less than their potential. By buying these units out from under their corporate parents and instituting real incentives (and disincentives), companies that were on their way down and out are rejuvenated.

It's true, certainly, that this process sometimes results in bloated enterprises becoming less bloated—that is, some jobs go away—but the net result of private equity activity is that many more jobs are created than are lost. In the case of Mitt Romney, the number was something like 140,000 net new jobs, and that didn't include jobs that were saved as uncompetitive companies were made more competitive.

I'm not carrying any water for Romney, but am simply making the point that capitalism necessarily involves creative destruction—not destruction, creative destruction. Certainly we need a safety net for folks whose jobs are eliminated, but once we begin to worry more about bad jobs lost than good jobs gained, we are in deep trouble as a society.

A Note to Financial Advisors

Let's assume that it is true, as I maintain, that private capital is the most important capital in the world. Let's also assume that it is true, as seems self-evident, that the owners of private capital are heavily dependent on their financial advisors for success. It therefore follows that the role of financial advisor to wealthy families is one of the most crucial jobs in America. That's why this book is directed to both wealthy families and their advisors.

Advising wealthy families is crucial, but it is also extraordinarily difficult. I've been doing the job for more than 30 years, and if I did it for another 30 years I would still have a lot to learn. What I do know I've put in this book. It's a long book, but it only scrapes the surface of its labyrinthine subject. If you work in this field you will encounter—almost daily—challenges that you have never run up against before. I hope you have partners to confer with about these challenges, but at the end of the day you will have to rely on the knowledge and skills you have accumulated over time, and on sound judgment.

Making matters worse, there is rarely one correct answer to any issue. When it comes to families and their human and financial capital, it's very difficult to know what the right course is.

Financial advisors will note that in Part Three—the hard-core investment portion of this book—I have sprinkled throughout the text a series of Practice Tips, set off in little boxes. In these Tips I've tried to interject ideas for providing successful wealth advice that have little to do with the details of investing capital and more to do with the hands-on experience of advising families. I hope my colleagues in the industry will find these useful.

A Note to Smaller Investors: The Moneybags© App

This book is addressed to families with very substantial capital to invest. But the truth of the matter is that, just as “a rose is a rose is a rose,” a best investment practice is a best investment practice, whether we are investing $10,000 or $100 million. For middle-income investors who are serious about the stewardship of their capital, this book may be worth looking into. Many best investment practices favored by large investors, after all, have been repackaged and made available to smaller investors.⁵ To assist smaller investors in translating the sophisticated strategies of the rich into actionable portfolios for middle income folks, I've developed the Moneybags^© app, a financial application that interprets the “best investment practices” in this book for portfolios as small as a few thousand dollars (or as large as a few million). More information about Moneybags is available at the very end of the book.

A Note to Institutional Investors

This is a book about the challenges of taxable investing, and hence many of the techniques I discuss are appropriate for family investors but may not be appropriate for nontaxable, institutional portfolios such as foundations, endowments, and pension plans. On the other hand, it will always be obvious when I am discussing a strategy that should be followed only by taxable investors. Hence the managers of institutional portfolios, and the members of endowment investment committees, may find much of interest in this book. That said, it is only fair to point out that the best book ever written on the management of nontaxable portfolios was published just a few years ago: David Swensen's Pioneering Portfolio Management,⁶ which should be required reading for all investors, institutional or otherwise.

Organization of the Book

Part One

Part One (Creative Capital) discusses the importance of private capital to the peculiar American version of free market democracy. Investment capital isn't something that exists in isolation from the broader society, nor is it a marginal factor in that society. If it were, the sound stewardship of capital would still be important to the families who have it, but it would be a matter of little consequence to the society at large.

In fact, however, private capital—both the lure of accumulating it and its disposition thereafter—is utterly essential to the way economic America works. It is the widespread and widely encouraged ability to become rich, and to be free to employ those riches in creative ways, that distinguishes American capitalism from its many cousins. After all, all free market democracies have strong middle classes, relatively free markets, and democratic forms of government. One might imagine that, as a result, all free market democracies would have roughly equivalent outcomes. We might assume that these economies would grow at about the same rates, with smaller economies naturally growing faster than larger economies (just as small companies grow faster than large companies), that innovation rates would be about the same across societies, that citizens of every country would work equally hard, that military strength would be roughly evenly distributed, and that each nation would export its pro rata share of the world's culture.

But, as we know, that has not been the case at all. Though it is true that most free market democracies operate on a roughly competitive plane, one of them—the United States—has so vastly outperformed the others that it has become the most dominant nation that ever existed. And even though the United States represents a huge portion of the global economy, far more than any other country, it continues to grow at rates more appropriate to emerging economies.

This has been, if we reflect on it, an astonishing outcome. In a postindustrial world of free societies, ideas migrate at the speed of light and innovation is no sooner made in one place than it is copied (or even improved) someplace else. In such a world, of all possible worlds, we would never have expected extraordinary dominance to arise.

I argue in Part One that American distinctiveness, American vitality, arises quite simply from the ongoing encouragement of American citizens to be productive by offering them the lure of great wealth, and by the resulting profusion of independently managed private capital—the most creative and least constrained source of capital in the world. I also speculate about why it is that America, far more than any of the older free market democracies, has managed to preserve its vigor. In other words, there are crucially important reasons why private capital needs to be managed properly, and those reasons go far beyond the narrow interests of the possessors of that capital. That is the message of Part One, and it provides the context for the rest of the book.

Part Two

Part Two (The Stewardship of Wealth) consists of six chapters (Chapters 4 through 8), each discussing a broad issue that investors of private capital face. Chapter 3, for example, is titled “Are We Living in a Permanent Financial Crisis?” The chapter argues that understanding what kind of world we will be investing our capital in matters a great deal. This chapter suggests that we are in for a great deal of difficulty in the intermediate-to-long-term future.

Chapter 4 discusses, from a variety of angles, the crucial concept of risk. Entire books have been written about investment risk, and even they can only scratch the surface of this complex topic. What I've tried to do is to give investors and their advisors a taste of the many kinds of risks capital faces.

Chapter 5 discusses the complex and disappointing world of finance as a business. I come down hard on my colleagues for the conflicts of interest that pervade the financial world, for the self-interest and utter lack of concern for clients, and for the corruption that has had global consequences.

Chapter 6 discusses the challenge of finding the right financial advisor for your family, and Chapter 7 discusses the even greater challenge of organizing your family to make sound and timely investment decisions.

Finally, in Chapter 8 I discuss the world of private trusts. Trusts are a prominent feature of every wealthy family, but organizing and managing trusts in sensible ways has become an increasing challenge as consolidation in the banking industry has eliminated most of the local trust banks.

Part Three

Part Three, The Rich Get Richer: The Nuts and Bolts of Successful Investing, is just that: a description of best investment practices in every important aspect of the investment process for private investors. Part Three consists of 14 chapters and is organized roughly in the order most families will take up investment issues. It is thus designed to be read straight through, from Chapter 9, which discusses the design of taxable investment portfolios, through Chapter 22, which discusses a variety of miscellaneous issues private investors face.

Part Three is by far the longest section of the book, and it will likely appeal more to financial advisors than to family members. However, I urge families at least to skim lightly over this material. It's very difficult to be a good client if you understand nothing about the details of the investment process.

Afterword

The afterword to this book attempts to make the important point that, after all, what matters in life is not wealth, but happiness. I argue that there is little about the struggle for happiness that is any different for wealthy families than for other families—in other words, that “All happy families are alike.” It is only the specific challenges that differ from those every family faces. I also point out that the one sure way for a wealthy family to become unhappy is for the family to fail in its stewardship obligations.

Writing this book has been a great pleasure for me, and I hope that reading it will bring at least a modest pleasure to my readers. For a small handful of them, perhaps, it will make a difference in the quality of their stewardship—and, therefore, in their personal happiness, the happiness of their children and grandchildren, and the continued success of the society that has nurtured them. It would be a rare writer who could ask for more.

Notes

¹ Rex Stout, The Mother Hunt (1963).

² See, generally, Charles Murray, Coming Apart: The State of White America, 1960–2010 (New York: Crown Forum, 2012).

³ There are many useful books that bear on the issue of stewardship, but Jay Hughes's classic book remains the best guide. See James E. Hughes Jr., Family Wealth—Keeping It in the Family: How Family Members and Their Advisers Preserve Human, Intellectual, and Financial Assets for Generations (New York: Bloomberg Press, 2004). This, incidentally, is the revised and expanded edition of Hughes's original book, published in 1997.

⁴ See Chapter 5.

⁵ I am thinking of such developments as money market funds, mutual funds, exchange-traded funds (ETFs), registered hedge funds, and so on.

⁶ New York: Free Press, 2000.

⁷ Preface, Living by the Word: Selected Writings 1973–1987 (New York: Harvest Books, 1989).

⁸ “Acknowledgements,” Schott's Original Miscellany (New York: Bloomsbury, 2003).

⁹ The reports are available on the Berkshire Hathaway website, www.berkshirehathaway.com.

¹⁰ New York: McGraw-Hill Trade, 4th ed., 2002.

¹¹ New York: HarperBusiness, rev. ed., 2003.

¹² New York: McGraw-Hill Trade, 2nd ed., 2002.

¹³ Available on the TIFF website at www.tiff.org.

¹⁴ www.Windhorsegroup.com

¹⁵ New York: Free Press, 2000.