Families and Investment Risk

Investing is the process of putting out money today in the hope or expectation that we will receive more money in the future. If the expectation that we will receive our capital back is very high, the return we can demand on it will be very low. This is because many, many other investors are happy to take very little risk and still receive a return.¹

Likewise, if the hope of having our capital returned intact is more speculative, we can demand a much higher return, because few other investors will have the appetite or ability to put their capital at significant risk. It's a simple matter of supply and demand, but mainly supply: There is always a great deal of demand for serious risk capital, but rarely much supply of it; there is a fairly static demand for low-risk capital (to finance the routine operations of governments and corporations), but there will always be a large supply of it.

Virtually every American family that is wealthy today got that way because someone in the family at some point took very serious risks. Yes, they also worked very hard and had a good idea. But one can work very hard and not become rich—coal miners, for example. And one can have brilliant ideas and not become rich—tinkerers and dreamers of all kinds. (“In the end, a vision without the ability to execute is probably a hallucination,” as Steve Case once put it.) It is the combination of hard work, a good idea, and risk that generates wealth on any significant scale.² The risk typically involves doing something new and different, or doing something old in a new and different way. The grander the idea, the larger the potential wealth—but also the greater the chance of a spectacular failure.

“Low”-Risk Investments

Risk in the context of liquid portfolios—post-sale of whatever made the family wealthy—is no different, but it operates on a more modest and more controllable scale. After all, once an investor has already become wealthy, the justification for continuing to take huge risks diminishes rapidly.

But large or small, risk is a tricky subject. Consider the safest investment in the world for a U.S. investor—a United States Treasury bill. (I say “a U.S. investor” because foreign investors must take currency risk when they buy U.S. Treasuries.) The likelihood that the U.S. government will default on its promise to pay us back in 90 days is so remote that it is fair to say, for most practical purposes, that U.S. Treasuries are risk-free investments.

Huge numbers of investors like this low-risk alternative, and consequently the U.S. government typically needs to offer a return no higher than the underlying inflation rate to attract capital. Because most buyers of U.S. government paper are tax-exempt institutions, the return on U.S. Treasuries tends to equal the inflation rate before tax. Taxable investors who buy Treasuries can therefore expect to receive negative real returns over time.

Hence the odd result that the “safest” investment in the world will destroy vast amounts of wealth if used exclusively in family portfolios over a very long period of time. For example, if a family had invested $100 million in U.S. Treasuries beginning 50 years ago and simply rolled the Treasuries over every 90 days for half a century, that family's wealth would have declined to the equivalent of about $60 million today (net of taxes and inflation, but assuming no spending). If the same family had put all its money in stocks compounding at 10 percent 50 years ago, that family would have today—net of taxes and inflation—something like $2.8 billion. The $2.6 billion difference between these two numbers is the long-term consequence of investing exclusively in the safest investment in the world.

“High”-Risk Investments

Let's compare the other end of the risk spectrum: early-stage venture capital investing. Venture capital is capital available to very new, untested companies. Early-stage venture capital investing involves the funding of new companies shortly after they have started up. Perhaps they have received initial capital from a “friends and family” investment round, or perhaps from a small group of angel investors. But the company is still new and untried, almost certainly unprofitable and possibly it even has no revenue stream. To say that such companies are risky investments is simply to state a truism: Many will fail altogether; others will sputter along, never completely returning their investor capital; a very few will succeed brilliantly.

Three or four decades ago, when the institutional venture capital world was in its infancy, a few intrepid investors—mainly families, not institutions—began to seek out and invest in early-stage venture companies. In those days the supply of capital for this sort of investing was almost nonexistent, given the huge risks involved and the lack of infrastructure in the industry. Consequently, annual returns could easily reach 40 percent or even 50 percent.³ Huge fortunes were made in this way.⁴

But those kinds of returns began to attract additional capital and talent to the business. As “deal flow” increased—that is, more entrepreneurs with ideas began to come along—investors began to form partnerships to source and nurture these fledgling enterprises, with the objective of eventually taking them public or selling them to larger firms. Today, the venture capital industry is fully developed in the United States, with hundreds of venture capital partnerships offering funding and advice to tens of thousands of entrepreneurs. Billions of dollars are raised every year by these partnerships.

But of course, the law of supply and demand holds: Returns have declined. Investors making diversified investments in early-stage venture capital partnerships today can expect to receive returns in the 15 percent to 35 percent range, depending on whether they are invested with top-tier or average partnerships. Although 20 percent annual compound returns are nothing to sniff at, given the capital risks and, especially, the illiquidity of these investments, few sensible investors would participate in early-stage venture investing in the hope of receiving 15 percent per year. On the other hand, savvy investors investing directly in deals, or participating in the best partnerships and diversifying by partnership, industry, stage, and time, can have a reasonable expectation of achieving 25 percent to 35 percent annual compound returns—probably the highest returns available outside the realm of pure speculation.

But whether the returns turn out to be closer to 15 percent or 35 percent, these are stunning returns from passive investing, and, given their favorable tax treatment, can easily produce huge increases in wealth for families who take the venture capital investing process seriously. Hence the odd result that, while the safest, low-risk investments will destroy wealth over time, the riskiest investments, properly structured, will almost certainly create significant real wealth.

“Reasonable”-Risk Investments: Marketable Securities

The core of most wealthy family portfolios will be marketable securities—stocks and bonds—and so I want to spend some time on the nature of risk in this sector of the market.

Stocks are issued by corporations through public or private offerings, but most of us buy stocks not directly from corporations (or, technically, the underwriters of the corporate stock offering) but from other investors, typically through the mechanism of a stock exchange. Indeed, the history of America is virtually coterminous with the history of the New York Stock Exchange, the largest exchange in the world, founded under a buttonwood tree near Wall Street in 1792. (The United States Constitution, you will recall, was ratified in 1788.)

Note that when we buy from other investors on a stock exchange our buying and selling is providing the liquidity without which no one would have bought the stock in the first place.