The Missing Billionaires E-Book

Victor Haghani

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 622

Veröffentlichungsjahr: 2023

Beschreibung

An Economist Best Book of the Year

"Making Money and Keeping It" – The Wall Street Journal

Over the past century, if the wealthiest families had spent a reasonable fraction of their wealth, paid taxes, invested in the stock market, and passed their wealth down to the next generation, there would be tens of thousands of billionaire heirs to generations-old fortunes today. The puzzle of The Missing Billionaires is why you cannot find one such billionaire on any current rich list. There are a number of explanations, but this book is focused on one mistake which is of profound importance to all investors: poor risk decisions, both in investing and spending. Many of these families didn’t choose bad investments– they sized them incorrectly– and allowed their spending decisions to amplify this mistake.

The Missing Billionaires book offers a simple yet powerful framework for making important lifetime financial decisions in a systematic and rational way. It's for readers with a baseline level of financial literacy, but doesn’t require a PhD. It fills the gap between personal finance books and the academic literature, bringing the valuable insights of academic finance to non-specialists.

Part One builds the theory of optimal investment sizing from first principles, starting with betting on biased coins. Part Two covers lifetime financial decision-making, with emphasis on the integration of investment, saving and spending decisions. Part Three covers practical implementation details, including how to calibrate your personal level of risk-aversion, and how to estimate the expected return and risk on a broad spectrum of investments.

The book is packed with case studies and anecdotes, including one about Victor’s investment with LTCM as a partner, and a bonus chapter on Liar’s Poker. The authors draw extensively on their own experiences as principals of Elm Wealth, a multi-billion-dollar wealth management practice, and prior to that on their years as arbitrage traders– Victor at Salomon Brothers and LTCM, and James at Nationsbank/CRT and Citadel.

Whether you are young and building wealth, an entrepreneur invested heavily in your own business, or at a stage where your primary focus is investing and spending, The Missing Billionaires: A Guide to Better Financial Decisions is your must-have resource for thoughtful financial decision-making.

Leseprobe

Table of Contents

Cover

Praise for

The Missing Billionaires

Title Page

Copyright

Dedication

Foreword

Preface

Who Is This Book For?

Notes

About the Authors

Acknowledgments

1 Introduction:  The Puzzle of the Missing Billionaires

Notes

I: Investment Sizing

2 Befuddled Betting on a Biased Coin

Introduction

The Experiment

Optimal Strategy

Findings: How Well Did Our Players Play?

Uncapped

Coin Flipping and the Stock Market

Connecting the Dots

Notes

3 Size Matters When It's for Real

Defining “Expected Value”

Maximizing Expected Wealth?

Maximize “Middle” Wealth?

Size Increases Lift and Drag

Goldilocks Bet-Sizing

Standard Deviation as a Measure of Risk

In Search of a General Rule of Thumb

The Kelly Criterion

Connecting the Dots

Notes

4 A Taste of the Merton Share

Should You Have a Static or Dynamic Allocation to Equities?

What Expected Return and Risk for the Stock Market Underlie the Traditional 60%/40% Portfolio?

What Would It Take to Be an All‐in Tesla Investor?

What About Really Small Investments?

Does Time Horizon Matter?

$1,000,000, No Tears

Connecting the Dots

Notes

5 How Much to Invest in the Stock Market?

Remember, It's Not All About Returns

Just a Good Draw?

Improvement in Sharpe Ratio Is a Twofer

Alternatives to Earnings Yield

Momentum

International Diversification

Turnover and Tax Efficiency

Merton Share Modification: Hedging Demand and Volatility Skew

Can Everyone Be a Dynamic Asset Allocator?

Not All Dynamic Asset Allocation Is “Market Timing”

Connecting the Dots

Notes

6 The Mechanics of Choice

Desire 101

A Silly Game Gives Birth to a Sensible Idea

The Happiness Curve

Expected Utility and Choice Theory

The One‐shape‐fits‐all Suite of Utility Functions

Utility User's Guide

Demystifying Utility with Certainty‐equivalence

Risk‐adjusted Return and the Price of Risk

A Penny Saved Is Two Pennies Earned

A Sharper Lens Than the Sharpe Ratio

Some Clarity on Risk Parity

When an Economist Calls You Irrational

Baby Needs a New Pair of Shoes, or Investing to Reach a Goal

Connecting the Dots

Notes

7 Criticisms of Expected Utility Decision‐making

This Isn't How Ordinary People Make Decisions

What Happens in Vegas…

Individuals Are Incapable of Specifying Their Personal Utility Functions

Prospect Theory and “Loss Aversion”

Criticisms of the Axioms of Rational Choice

Wicked Games

Probabilities of Future Outcomes Are Unknowable

The Kelly Criterion Is Good; Expected Utility Is Bad

Expected Utility for Life and Death Choices

So Why Isn't Everyone Using Expected Utility Already?

Connecting the Dots

Notes

8 Reminiscences of a Hedge Fund Operator

Background

The Big Decision

Would've, Should've, Could've

(Un)common Sense

Notes

II: Lifetime Spending and Investing

9 Spending and Investing in Retirement

What Do Good Solutions Look Like?

The Merton‐Samuelson “Lifetime Consumption and Portfolio Choice” Framework

Applying the Model to a Real‐life Situation

How Does This Compare to Other Popular Rules?

Updating Your Investment and Spending Plans

Why Don't More Advisors Use This Approach?

Extensions

Connecting the Dots

Notes

10 Spending Like You'll Live Forever

Three Spending Policy Options

How to Compare Different Spending Policies

Time Preference: Weighing a Better Present Against a Better Future

Comparing Spending Policies

The Optimal Spending Policy for the Very Long Term

Putting Theory into Practice

Accounting for Assets and Liabilities Beyond the Endowment's Investment Portfolio

Extensions to More Complex Situations

Family Wealth

Other Popular Spending Policies

Connecting the Dots

Notes

11 Spending Like You

Won't

Live Forever

The Annuity Puzzle

How Big a Free Lunch Is Being Left on the Table?

Annuities and End‐of‐Life Bequests

Annuities and Equities

Annuities Versus Bonds

Connecting the Dots

Notes

III: Where the Rubber Meets the Road

12 Measuring the Fabric of Felicity

Is Less More with Risk‐Aversion?

How Wealth Delivers Utility

Intergenerational Bequests

Philanthropy

Subsistence Spending and Wealth

Plumbing the Depths of Despair

Risk‐Seeking at Low Wealth: Friedman‐Savage Utility

Predictable Changes in Preferences: Habit Formation

Utility from Wealth, in and of Itself

Time Preference

Connecting the Dots

Notes

13 Human Capital

What Is Human Capital?

Human Capital and Lifetime Spending Decisions

Are You a Stock or a Bond?

Young Investors: High on Human Capital, Low on Financial Capital

Protecting Your Human Capital: The Case for Life Insurance

When Can I Retire?

Connecting the Dots

Notes

14 Into the Weeds: Characteristics of Major Asset Classes

Long‐term Inflation‐linked Government Bonds

Nominal Government Bills and Bonds

Stock Markets

Foreign Equity Markets

Index Funds

Corporate Bonds and Other Risky Lending

Real Estate

Actively Managed Mutual Funds

Factor Investing

g

ESG Investing

Individual Stocks

Options

Special Situations and Near‐risk‐free “Arbitrage” Investments

Alternative Investments: Private Equity, Venture Capital, Hedge Funds, and Private Real Estate

Commodities, Art, Collectibles, and Crypto

Building Your Multi‐asset Portfolio

Connecting the Dots: The “Smell Test”

Notes

15 No Place to Hide: Investing in a World with No Safe Asset

Your Personalized Standard of Living Index

From Personalized Standard of Living to Personalized Risk‐free Asset

How Safe Are T‐Bills, Really?

Equities: A Sheep in Wolf's Clothing?

What If There's No Perfectly Safe Asset?

How Your Personal Standard of Living Index Impacts Your Optimal Spending

Connecting the Dots

Notes

16 What About Options?

Using Expected Utility to Measure Whether Options Are Making Us Better Off

Two‐asset Case with Continuous Rebalancing: Fair Options Don't Improve Investor Welfare

No Dynamic Rebalancing: Fair Options Can Add Value, but Not Much

Options as Portfolio Insurance

Buying Options Helps If Equities Become Less Attractive After a Drop

How Can We Tell If Options Are Fairly Priced?

If They're Expensive, Why Not a Seller Be?

Options and Life Cycle Investing

Options on Single Stocks: Two Times Zero Is Still Zero

Options as Lottery Tickets

Beyond Vanilla Listed Stock Options

Hedging the Options You're Stuck With

Connecting the Dots

Notes

17 Tax Matters

To Realize or Not to Realize

How Much Should the Tax Tail Wag the Asset Allocation Dog?

Optimal Equity Allocation with Unrealized Gains

Tax Loss Harvesting

The Bane of King Lear

Extensions

Connecting the Dots

Notes

18 Risk Versus Uncertainty

Introduction

The Two Envelopes Paradox: We're All Bayesians Now

Learning

The Ellsberg Puzzle

The Shape of Uncertainty

Parameter Uncertainty with Multiple Risky Assets

Connecting the Dots

Notes

IV: Puzzles

19 How Can a Great Lottery Be a Bad Bet?

Connecting the Dots

Notes

20 The Equity Risk Premium Puzzle

Connecting the Dots

Notes

21 The Perpetuity Paradox and Negative Interest Rates

Negative Rates and Ultra‐long‐term Bonds

The Perpetuity Paradox Finds Expected Utility in St. Petersburg

Connecting the Dots

Notes

22 When Less Is More

Crypto Risk and Return

Explaining the Hump

A Different Perspective on Wealth and Risk

Connecting the Dots

Note

23 The Costanza Trade

Seinfeld Season 10: The ETF Episode

Leveraged ETF Returns: Not What George Was Expecting

Sizing Your Stock Market Exposure for the Long Term

Opposite George?

Connecting the Dots

Notes

24 Conclusion: U and Your Wealth

Notes

Bonus Chapter: Liar's Poker and Learning to Bet Smart

Note

Cheat Sheet

A Few Rules of Thumb

Suggested Reading

References

Index

End User License Agreement

List of Tables

Chapter 2

Table 2.1

Chapter 3

Table 3.1 Calculating Expected Payout

Table 3.2 Expected Wealth Over a Range of Betting Fractions

Table 3.3 Most Likely Wealth Over a Range of Betting Fractions

Table 3.4 Betting “Heads” on 25 Flips of a 60/40 Biased Coin, $1mm Starting ...

Chapter 6

Table 6.1 Expected Utility of St. Petersburg Game

Table 6.2

Table 6.3 Three Investments with Same Expected Gain and Risk but Varying Sym...

Chapter 8

Table 8.1 Assumptions Needed for Expected Utility Analysis

Chapter 9

Table 9.1 Sam Case Study: 65 Years Old, Retired, $1mm of Savings, 20 Years t...

Table 9.2 Assumptions Behind Sam’s Optimal Investment and Spending Policy

Table 9.3 Sam: Fixed Spending vs Utility Optimal Variable Spending (60% in U...

Chapter 10

Table 10.1 Investment Environment and Policy Assumptions

Table 10.2 Comparing Spending Rules: Size of Endowment Needed to Generate Eq...

Chapter 14

Table 14.1

Chapter 16

Table 16.1 Base‐Case Investor Assumptions

Chapter 17

Table 17.1 Assumptions for Capital Gains Tax Realization Decision

Chapter 18

Table 18.1

Chapter 23

Table 23.1

List of Illustrations

Chapter 2

Exhibit 2.1 Summary of Coin Flipper Performance: Betting on a Coin with Disc...

Chapter 4

Exhibit 4.1 Return Versus Risk Trade‐offs to Justify 60/40 Stock/Bond Alloca...

Chapter 5

Exhibit 5.1 Next 10‐year Realized Real Return Versus Earnings Yield at Start...

Exhibit 5.2 Allocation to US Equities Based on Merton Share Using Excess Ear...

Exhibit 5.3 Excess Earnings Yield Dynamic Versus Static Asset Allocation, US...

Exhibit 5.4 US Equities: Earnings Yield Minus Real Yield and Real Yield 1900...

Exhibit 5.5 Excess Earnings Yield Dynamic Versus Static Asset Allocation: US...

Exhibit 5.6 Excess Earnings Yield Dynamic Versus Static Asset Allocation Usi...

Chapter 6

Exhibit 6.1 Concave Utility Curve and Decreasing Marginal Utility of Wealth...

Exhibit 6.2 Constant Relative Risk‐aversion Utility With Different Levels of...

Exhibit 6.3 Expected Return and Utility over a Range of Bet Sizes For a Sing...

Exhibit 6.4 Expected Return, RAR and Price of Risk Over Range of Bet Sizes F...

Exhibit 6.5 Impact of Investment Symmetry on Risk‐adjusted Return

Exhibit 6.6 Comparing Wealth Outcomes for Goal‐based Investing Versus Consta...

Chapter 7

Exhibit 7.1 Prospect Theory Versus Classical Utility Preferences

Chapter 8

Exhibit 8.1 Risk‐adjusted Return as Function of Percentage of Liquid Wealth ...

Chapter 9

Exhibit 9.1 Spending and Investing Rules and Spending and Portfolio Value St...

Chapter 10

Exhibit 10.1 Policy 1: Spend a Fixed Annual Amount Equal to the Expected Sim...

Exhibit 10.2 Policy 2: Spend a Fixed Annual Percentage of the Endowment Valu...

Exhibit 10.3 Policy 3: Spend a Fixed Annual Percentage of the Endowment Valu...

Exhibit 10.4 Median Spending Under Optimal and Sustainable Spending Policies...

Chapter 11

Exhibit 11.1 Longevity Probabilities for 65‐year‐old Female From US Social S...

Exhibit 11.2 Comparing Self‐Managed Versus Annuity Annual Expenditure for Sa...

Chapter 12

Exhibit 12.1 Survey Responses

Exhibit 12.2 Utility Curve With Higher Risk‐aversion Below Subsistence Level...

Exhibit 12.3 Friedman‐Savage Utility Curve Incorporating Intermediate Range ...

Chapter 13

Exhibit 13.1 Typical Lifetime Earning and Spending Pattern

Chapter 14

Exhibit 14.1 Stock Price Probability Distribution: 10% per Annum Expected Ex...

Chapter 16

Exhibit 16.1 Contribution of Puts Versus Portfolio Leverage: Increase in Ris...

Chapter 17

Exhibit 17.1 How Much Appreciated Asset to Sell?

Exhibit 17.2 Optimal Equity Allocation With and Without Taxes for Different ...

Chapter 18

Exhibit 18.1 Multi‐Round Ellsberg Experiment: $100 Prize for Choosing Red Ba...

Exhibit 18.2 Less than 1% Difference in Optimal Allocation to Equities Under...

Chapter 21

Exhibit 21.1 Price of 100‐year, 1,000‐year and Perpetual Annuities: Present ...

Chapter 22

Exhibit 22.1 How Much to Wager on a Digital Asset as Payout Becomes More Fav...

Chapter 23

Exhibit 23.1 3x Leveraged Long ETF Predicted Return Versus Unleveraged Index...

Guide

Cover Page

Praise for The Missing Billionaires

Title Page

Copyright

Dedication

Foreword

Preface

About the Authors

Acknowledgments

Table of Contents

Begin Reading

Bonus Chapter: Liar's Poker and Learning to Bet Smart

Cheat Sheet

A Few Rules of Thumb

Suggested Reading

References

Index

Wiley End User License Agreement

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Praise for The Missing Billionaires

This is a marvelous book that importantly extends the literature on financial decision‐making. The authors creatively weave together the essence of practical considerations with insightful academic theory. One of a small handful of books that is timeless and should be read and reread over a lifetime for enjoyment and substance.

—Gary P. Brinson, CFA, Author, and Founder of Brinson Partners

The missing billionaires in the book's title allude to the difficulty of keeping already‐made fortunes. Believing that nobody should get rich twice, Victor and James arm investors with lessons galore, drawn from their long practitioner careers. Yet the core lessons come from academia, and this wonderful book gives the best shot for Expected Utility and lifecycle models to finally become widely used in real‐world investment decision‐making. Uniquely, this book puts position sizing in the center, showing through many illustrations how “too much of a good thing” can be just too much.

—Antti Ilmanen, Principal at AQR Capital, Author of Expected Returns

The Missing Billionaires addresses a topic that gets far too little attention in the investment community: how much to invest. The book is a terrific blend of theory, practice, and stories from the front lines. This is must‐reading for anyone seeking to invest and spend wisely.

—Michael Mauboussin, Author and Head of Consilient Research, Morgan Stanley

I enjoyed and learned from Victor and James’ book on incorporating uncertainty directly into making better financial decisions. Rightly so, for them, risk is front and center. This book is a great education for all of us, seamlessly marrying sophisticated theory with applications, demonstrating the beauty of a risk architecture that combines specificity with illuminating implementations into the lifetime wealth management problem.

—Myron S. Scholes, Frank E. Buck Professor of Finance, Emeritus, Stanford Graduate School of Business, Nobel Laureate in Economic Sciences

THE MISSING BILLIONAIRES

A GUIDE TO BETTER FINANCIAL DECISIONS

VICTOR HAGHANIJAMES WHITE

Copyright © 2023 by Victor Haghani and James White. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 750‐4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at http://www.wiley.com/go/permission.

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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Further, readers should be aware that websites listed in this work may have changed or disappeared between when this work was written and when it is read. Neither the publisher nor authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging‐in‐Publication Data is Available:

ISBN 9781119747918 (Hardback)

ISBN 9781119747932 (ePDF)

ISBN 9781119747925 (ePub)

Cover Design: Wiley

Cover Image: Jeffrey Rosenbluth

Author Photos: Courtesy of the Authors

To my mother and father, Lucille and Moosa, for their love and for bringing me into the world at the best possible time. To my three children, Josh, Jess, and Mark, for giving meaning to everything I do. And to my wife, Celeste, for your love and boundless understanding.

VJH

Foreword

In the first pages of this excellent new book by Victor Haghani and James White, you are going to meet Cornelius “Commodore” Vanderbilt. The name is of course familiar and a quick search on the internet will tell you that he died in 1877, leaving his eldest son, Billy, more than a hundred million dollars, the largest fortune in the world at that time. The family grew and expected to live luxuriously. Asset returns have been so strong over the past 150 years that Cornelius’ heirs today should all be worth more than $1 billion each. It didn't turn out that way for the Vanderbilts. By the 1950s, there was not a single descendant of Cornelius who was a millionaire, let alone a billionaire. The Vanderbilt family tree is a conspicuous, but not unusual, example of the “billionaires manqués” that highlight the importance, and the challenge, of making good financial decisions.

When Victor first told me this story over dinner, I suggested many explanations: war, taxes, divorce, the crash of 1929. But none of them held up to scrutiny. We settled on two: the Vanderbilts did a poor job sizing their investment risk (too much concentration) and failed to connect their spending practices to their risk‐taking.

This book is profoundly novel in the personal finance literature in its focus on investment sizing rather than investment selection. Victor and James develop a logical and practical framework for thinking through these important “how much” decisions we face in our financial lives, such as how much to allocate between stocks and bonds, how much to spend, or how much capital gains tax to pay. This is especially important in a time of great uncertainty in asset prices, interest rates, inflation, taxation, and even individual longevity.

I believe this book is destined to become a Wall Street classic, to be passed down by generations of trading floor veterans who are passionate about markets and thoughtful about risk. I hope it will serve as an antidote to the stories of wild risk‐taking glorified in Reminiscences of a Stock Operator, a dog‐eared copy of which was handed down to me when I was just starting out. I also expect The Missing Billionaires will become an important gift from parents to their children, and beyond.

Victor and James are skilled at explaining difficult concepts in a down‐to‐earth, intuitive fashion, providing a practical toolkit that readers can use to organize their financial lives. This book will benefit both financially educated readers and readers for whom all this material is quite new. It's packed with case studies and anecdotes that bring the core concepts to life. The authors combine a deep understanding of the academic finance literature with their own extensive experience as finance professionals, both as arbitrage traders and then as the principals of Elm Wealth, their multi‐billion‐dollar wealth management practice.

For 20 years, Victor and I hosted a regular dinner where we would discuss analytical finance problems over kebabs and decent red wine. A perfect fuel for such a dinner would have been Chapter 8, where you'll find the first inside account by an LTCM partner of the decisions faced over the short but eventful life of the much‐studied hedge fund. The lessons learned apply just as much to a tech start‐up deciding how much cash to hold between rounds of financing or to getting into an Uber where the driver does not look one bit like the picture on your phone (likely a bad idea). The discussion will force you to think about how to incorporate low‐probability, high‐consequence tail events into your decision‐making. Its humility is sobering.

Finance took an unexpected turn in 1973 when Fischer Black and Myron Scholes published their now‐famous paper on option pricing. For 50 years, academic researchers and practitioners have built upon their work. It is not obvious to me what good it has done for individual investors, although it has helped banks create, and profit from, many complicated derivatives (full disclosure: a long time ago, I worked in equity derivatives at Goldman Sachs).

You will learn about another seminal paper published four years earlier in 1969 by Robert Merton, about how much to put in the stock market and what fraction of your wealth to spend each year as you age. This paper has been largely forgotten outside academia, just like the 1956 paper by John Kelly on how to optimize the growth of wealth. Victor and James place the ideas of these papers at the core of the book. They will give you a framework for thinking about whether you're taking too little or too much risk and how to match your spending to the risks you're taking.

Spending from one's wealth in retirement is an important problem, one that I devote a lot of time to at PIMCO in my day job and also through my involvement with the University of Chicago's Roman Family Center for Decision Research. Taxes matter, longevity matters, spending matters, and drawdowns matter. You will find in Section II a full discussion of these topics, and in Section III some excellent unbiased advice on how to practically use these ideas to keep your financial life in order.

Adventurous readers will be rewarded by taking time to read Section IV. Here you will find a set of fascinating puzzles that can be unlocked with the key concepts of the book. This is a book you'll want on your shelf to think through thorny issues again and again. It is a must‐have resource for anyone seeking to make informed and thoughtful financial decisions at any stage of life, whether you're a young investor building wealth, an entrepreneur invested heavily in your own business, or at a stage where your primary focus is investing, spending, and giving.

I started working at Goldman Sachs in New York City in July 1987 and have been lucky to ride a wonderful slow wave of strong equity and fixed income returns. But despite this very favorable backdrop, I have observed near‐inexplicable financial decisions by numerous wealthy and highly intelligent people, many of whom would count in Victor and James’ tally of “missing billionaires.” I have also seen my own approach to financial decision‐making evolve with time and experience. I am happy to say my thinking has tended to converge with the ideas of this book, but not as quickly as I wish they had. Victor and James say that they wrote this book with their younger selves in mind. They are not the only ones who would have benefited from reading this book decades ago. It is a gift I intend to give frequently!

Emmanuel RomanCEO, PIMCONewport Beach, CAApril 2023

Preface

There are thousands of books on personal finance.a Unfortunately, by and large, these books do not agree with one another, leaving the seeker of sound financial advice adrift. In contrast, textbooks written for university courses on financial decision‐making closely agree.1 Given this harmony among professors writing textbooks, you'd think that when they turn their attention to writing books for a wider, nonacademic audience, they'd deliver a consistent, unified message. Alas, this is not the case. For example, one distinguished professor writes a book titled A Random Walk Down Wall Street, and another gives us A Nonrandom Walk Down Wall Street. We have one advocating investing heavily in Stocks for the Long Run, and another warning us of stock market Irrational Exuberance. Some tell us to only invest in low‐cost index funds, while another, in The Little Book That Beats the Market, suggests we invest in a handful of stocks that will deliver exceptional returns. Then there are two MIT‐minted professors, one who suggests we should Risk Less and mostly invest in safe government bonds, while the other advocates that young adults hold a two times leveraged exposure to stocks. And these are just the books by the professors.

Perhaps it's less surprising that we get diametrically opposed advice from industry titans advocating their own firm's offerings. For example, Vanguard founder John Bogle preached the benefits of index funds in The Little Book of Common Sense Investing, while the legendary (retired) manager of Fidelity's stock‐picking Magellan Fund, Peter Lynch, encourages investors to try to beat the market by picking stocks that make products they like in his popular One Up On Wall Street. The cacophony of advice grows louder still, and its deviation from economic theory becomes more unsettling, when we survey the whole of the popular personal finance literature, including such titles as Rich Dad, Poor Dad or The Millionaire Next Door.2

One reason behind this disturbing divergence of financial advice is that most books on personal finance assume a typical reader, subject to typical circumstances, and then endeavor to tell that reader what to do. Different assumptions about who and what is typical can lead to dramatically different recommendations. In writing this book, we have been motivated by the proverb, “Give a man a fish, and he won't be hungry for a day; teach a man to fish, and he won't be hungry for a lifetime.” Our intent is to give you a practical framework, consistent with the consensus of university finance textbooks, for making good financial decisions that are right for you. Good decisions will take account of your personal circumstances, financial preferences, and your considered views on the risks and expected returns of available investments.

Who Is This Book For?

This book is for anyone who feels that making better financial decisions can materially improve their welfare. You will likely get the most out of this book if you have already accumulated a decent amount of financial capital or if you are young with a healthy measure of human capital. A good number of our readers will be finance industry professionals, who we trust will find ideas in this book that they haven't encountered in their day jobs. We focus primarily on individuals and families rather than institutional investors, although many of the concepts we discuss are relevant to all stewards of capital.

We assume the reader is familiar with common investment products (stocks, bonds, mutual funds, index funds, ETFs, options) and concepts (compound return, time value of money, yield‐to‐maturity, inflation). We acknowledge and respect the intelligence of our readers by refraining from giving blindingly obvious advice, such as the merit of paying off credit card debt accruing at 20% interest with cash sitting in the bank earning 2% interest, or that you should avoid paying higher fees or taxes than necessary. We also recognize that all of us wrestle with a long list of cognitive biases in our decision‐making, but we trust that you are like we are in wanting to conquer these foibles and make better decisions. Indeed, there is little else we can do, once we acknowledge that not deciding is itself a decision.

For readers who want to build or refresh their knowledge of finance basics before diving into this book, we recommend taking a short, free online course such as “Financial Markets” by Robert Shiller on Coursera. Basic high school math proficiency, including comfort with ideas expressed using symbols and words, is all that's needed to fully understand every concept in this book. We have used shaded technical sidebars to give more mathematically inclined readers a deeper dive, but these can be skipped over without any loss of understanding. We have also used unshaded sidebars to tell stories from our personal adventures in finance and have included several chapters of puzzles that help illustrate key concepts. We use footnotes at the bottom of each page for interesting but nonessential musings, and we employ endnotes to give credit and references, state further assumptions, deal with technical minutiae, or expand on topics beyond the scope of the core text. Each chapter is headed with a cartoon illustration drawn by the very talented Paul Bloomfield, which we hope will help you remember the main landmarks and path of your reading journey.

The book is written from the perspective of a US individual or family, and many of the examples, particularly involving taxation and retirement products, are set in the US context. We hope this doesn't detract from the value that non‐US readers can derive, as the concepts and framework we describe can be adapted to any setting.

Of course, all authors hope their books will be useful to as broad an audience as possible. Regardless of your background, we hope to persuade you through practical examples and applications that the financial decision‐making framework we describe herein is sensible and eminently practical.

Wishing you tight lines, bent rods, and full nets!

We value your feedback and would love to hear your thoughts, experiences, questions, or suggestions. We'll be keeping a running discussion of our interaction with our readers who are comfortable sharing our dialogue publicly on this page of our website, www.elmwealth.com/MissingBillionaires.

Notes

a

3,537 to be precise, according to the US Library of Congress.

1.

For example, Back, 2017; Campbell, 2017; Cochrane, 2005; Huang & Litzenberger, 1988; Ingersoll, 1987; Skiadas, 2009.

2.

Ranked first and second on the list of personal finance books on website

Goodreads.com

December 2022. [

https://www.goodreads.com/shelf/show/personal-finance

]. See James Choi (2022),

Popular personal financial advice versus the professors

, National Bureau of Economic Research.

About the Authors

Victor Haghani has spent four decades actively involved in markets and financial innovation. He started his career in 1984 at Salomon Brothers in bond research. He moved to the trading floor in 1986 and shortly after became a managing director in the bond arbitrage group run by John Meriwether. In 1993, Victor was a cofounding partner of Long‐Term Capital Management (LTCM). He established and co‐ran its London office. His participation in the failure of LTCM was a life‐changing experience that led him to question and revise much of the way he thought about the economy, markets, and investing.

Through a careful study of the academic literature on investing and many thought‐provoking discussions with friends, colleagues, and investors of all backgrounds, Victor concluded that savers can and should do much better. He founded Elm Wealth in 2011 to help investors, including his own family, manage their savings in a disciplined, research‐based, cost‐effective manner and to capture the long‐term returns they ought to earn.

In his 2013 TEDx talk, Where Are All the Billionaires and Why Should We Care?, Victor shared his perspective on the synthesis of active and passive investing, which forms the basis of the Dynamic Index Investing® approach offered by Elm Wealth. Over the years, Victor became fascinated with the challenge of making good decisions on broader questions about wealth and personal finances, including sound spending policies, tax decisions, and retirement choices.

Victor was born in New York City in 1962 and grew up in New York, Pennsylvania, Tehran, and London. As an adult, he has resided in New York City and London and, more recently, has been based in Jackson Hole, Wyoming. Victor graduated from the London School of Economics (LSE) in 1984 with a B.Sc. (economics). He has been a prolific contributor to the academic and practitioner finance literature.

Victor has been involved in a variety of other activities, including research and lecturing at the LSE, where he was a senior research associate in the Financial Markets Group, as well as consulting and board assignments and acting as a “name” in the Lloyd's of London insurance market. He loves the outdoors and is an avid skier, hiker, and fisherman and enjoys taking long walks with his dog Milo. He has always been fascinated by airplanes, flying model ones as a boy and full‐size ones as an adult.

James White has spent two decades working in finance, covering the gamut of quantitative research, market‐making, hedge fund investing, private equity investing, and wealth management. He has been the chief executive officer (CEO) of Elm Wealth since 2018, working with Victor to help friends, family, and clients sensibly and efficiently invest their wealth. After meeting through a mutual friend, James and Victor began working on research and writing together, sharing ideas, and collaborating regularly. After James built the next generation of Elm's portfolio management systems, he and Victor were talking and working together every day so joining Elm as the CEO just seemed natural.

Since then James has moved to Philadelphia to establish Elm's headquarters and has seen the business grow to serve hundreds of families and manage around $1.5 billion of their assets. He splits his time between working with clients, continuing to develop and improve Elm's systems, and research and writing.

After studying math at the University of Chicago, James lived and worked all over the world, first for Nationsbank/CRT and Bank of America, then for Citadel Investment Group, then as a partner at PAC Partners, a boutique private investment firm. His interest in optimal trade‐sizing and risk‐taking arose from each of these experiences and has culminated in the way Elm Wealth advises and invests for clients today.

James is an avid rock climber, classical guitarist, cook, and lover of renaissance history and music. When not in Elm's office or visiting clients, he can usually be found out climbing, hiking, eating, or traveling somewhere that nicely incorporates all three.

Acknowledgments

We owe a debt of gratitude to the many people who have contributed to our financial education, in both theory and practice, and to our professional and personal development. We have been blessed to have patient and caring teachers right from the start of our careers, including (for Victor) Bob Kopprasch, Bill Krasker, Robert Merton, Chi‐fu Huang, and Myron Scholes, and (for James) Sean Becketti, Nessan Fitzmaurice, and Vladimir Piterbarg. We thank our colleagues and co‐travelers who have shared so much of their wisdom and experience with us, in particular John Meriwether, Larry Hilibrand, Rob Stavis, Richard Leahy, Eric Rosenfeld, Samir Bouaoudia, Larry Bernstein, Ephi Gildor, Hans Hufschmid, Hedi Kallal, David Heatley, Lord Jacob Rothschild, and Alan Howard. We have learned so much from each of you.

Hedi Kallal first introduced us and saw that we were both on the same intellectual journey and would benefit from traveling it together. Without his inspired and fortuitous introduction, neither this book nor our friendship would have happened, for which we owe him tremendous thanks.

Our friends' generous contributions to this book have been tremendous and humbling. Thank you to Antti Ilmanen for your boundless encouragement, your introduction to our editors at Wiley, and your many valuable comments and corrections. Jeff Rosenbluth and Larry Hilibrand went far, far beyond the call of friendship in the countless hours they spent reviewing and shaping the manuscript, not to mention contributing many of the core ideas of the book. Others who gave much of their time to the development of the book include Ayman Hindy, Richard Dewey, John Glazer, Vladimir Ragulin, and John Karubian. We also received valuable comments and corrections from Jamil Baz, Bruce Tuckman, Steve Mobbs, José Scheinkman, Peter Hirsch, Saman Majd, Arjun Krishnamachar, Bill Montgomery, Ian Hall, Aneet Chachra, Adrian Eterovic, and Anna Wroblewska. We thank our colleagues Mike Fothergill and Steven Schneider for their help on numerous aspects of the book. Victor's three children, Josh, Jess, and Mark, all served as sounding boards for the quality of our explanations and offered many other useful suggestions. The positive feedback on our short‐form writing that we received from professional finance writers Jason Zweig, Michael Mauboussin, John O'Sullivan, Joe Weisenthal, Spencer Jakob, and John Authers made us believe we had a book in us. The prolific writer and financial impresario Frank Fabozzi was the first to publish our work in his anthologies and in the academic journals for which he has served as editor.

Our understanding has been shaped by many deep thinkers and writers in finance who have generously shared their insights through academic articles, lectures, and books, including John Campbell, Robert Shiller, John Cochrane, Phil Tetlock, Ed Thorp, Cliff Asness, and Howard Marks. We thank our coauthors of previous articles, which provide the foundation of several chapters of the book, including Rich Dewey, Vlad Ragulin, Larry Hilibrand, Jeff Rosenbluth, and Andy Morton. There are many people at Wiley who helped make this book a reality, and we thank them all, but in particular we must sing the praises of our publisher, Bill Falloon, whose wisdom, good nature, and patience are responsible for this book coming to life. We'd be pleased if some readers decide to judge our book by its cover art, generated by our multi‐talented friend Jeff Rosenbluth.

We are grateful that our dear friend Manny Roman graciously agreed to write the foreword to the book, carving out time from his day job of running the world's largest bond investor, PIMCO. We hope he will one day write a book himself or perhaps publish a collection of his poetry for all to enjoy. We thank Michael Lewis and Matt Levine for their friendship and their inspiration, showing us that it is possible to write about finance in a manner that makes the heart race while conveying valuable and astute insights.

For those of you who have been readers of our monthly Thought Pieces over the past decade, we heartily thank you and have found your steadfast interest and feedback invaluable in spurring us on to writing this book. We are beholden to our clients at Elm Wealth for their trust and openness in giving us an opportunity to develop and test the practicality of many of the ideas we discuss in this book. Finally, we must thank all those “missing billionaires” who have helped us realize that there was a book that needed to be written about making better financial decisions.

1Introduction:  The Puzzle of the Missing Billionaires

Any fool can make a fortune; it takes a man of brains to hold onto it.

—Cornelius “Commodore” Vanderbilt

A beautiful statue of Cornelius Vanderbilt, the nineteenth‐century rail and shipping tycoon, adorns the outside of Grand Central Station in New York City. It's there because “the Commodore” ordered the station's construction. Although partially obscured today by an eyesore called the Park Avenue Viaduct, the statue sits right at the heart of midtown Manhattan, the global center of finance, regularly visible to many of today's financial titans.

When Vanderbilt died in 1877, he was the wealthiest man in the world. His eldest son, Billy, received an inheritance of one hundred million dollars—95% of Cornelius' fortune. Unfortunately, it came without even the most basic of instructions on how to invest and spend this wealth over time. Within 70 years of the Commodore's death, the family wealth was largely dissipated. Today, not one Vanderbilt descendant can trace his or her wealth to the vast fortune Cornelius bequeathed.a The Vanderbilt clan grew at a higher rate than the average American family, but even so this outcome was far from guaranteed. If the Vanderbilt heirs had invested their wealth in a boring but diversified portfolio of US companies, spent 2% of their wealth each year, and paid their taxes, each one living today would still have a fortune of more than five billion dollars.

What went wrong?

‐‐‐‐‐‐‐‐‐‐‐‐‐‐

The Vanderbilt experience is noteworthy in scale but not in substance. The dissipation of great wealth over just a few generations is a common enough occurrence to warrant its own maxim: “from shirtsleeves to shirtsleeves in three generations.” The truth of this dictum can be seen in how remarkably few of the billionaires in the news these days are the scions of old‐money wealth. From these observations, we can tease out a valuable insight: the wealthiest families of the past were not equipped to consistently make sensible investing and spending decisions. If they had been, their billionaire descendants would vastly outnumber today's newly minted variety.

To get a rough count of these “missing billionaires,” let's turn back the clock to 1900. At that time, the US census recorded about four thousand American millionaires, with the very richest counting their wealth in the hundreds of millions. If a family with five million dollars back then had invested their wealth in the US stock market and spent from it at a reasonable rate, that single family would have generated about 16 billionaire households today.b If even a quarter of those millionaires in 1900 started with at least five million dollars, their descendants alone should include close to 16,000 old‐money billionaires alive today. If we include the private wealth created throughout the twentieth century as well, rather than just a snapshot in 1900, we believe the tally of potential billionaires is vastly greater.

But as of 2022, Forbes estimated there were just over 700 billionaires in the United States, and you'll struggle to find a single one who traces his or her wealth back to a millionaire ancestor from 1900. We needn't go so far back in the past to find this pattern. Fewer than 10% of today's US billionaires are descended from members of the first Forbes 400 Rich List published in 1982. Even the least wealthy family on that 1982 list, with “just” $100 million, should have spawned four billionaire families today. We recognize that some wealthy families purposefully chose to give away or consume virtually all of their wealth in their lifetimes, but we believe these cases were relatively rare and do not account for the near‐complete absence of “old‐money” billionaires we see today.

We're not lamenting a scarcity of billionaires in the world today. Our point is that, collectively, we all face a really big and pervasive problem when it comes to making good financial decisions. If even the most financially successful members of our society, at least some of whom were smart and capable, and all of whom could afford the “best” financial advice, consistently made atrocious financial decisions, what can be expected from the rest of us? There's a Persian proverb Victor's father was fond of, which seems improbable at first, but the truth of which has become a main motivation for this book: “It's more difficult to hold on to wealth than it is to make it.” This book sets forth our framework for addressing the challenge faced by all families—not only potential and actual billionaires—to find a path to better financial decisions.

In the chapters that follow, we're going to explore in detail the most common ways in which these missing billionaire families discarded their enormous head start: taking too much or too little risk, spending more than their wealth could support, and not adjusting their spending as their wealth fluctuated. Above all, they did not have a unified decision‐making framework, which left them susceptible to chasing whatever was hot and dumping it as soon as it was not, anchoring spending decisions on hoped‐for portfolio returns, and paying exorbitant fees for poor advice.

Notice that among the primary errors we listed, we did not include choosing bad investments. That's because one thing that did not cause these billionaires to go missing was a poor investment environment. Indeed, it's hard to imagine a better one. The US stock market delivered a 10% pretax annual return over the period, turning one million dollars in 1900 into roughly one hundred billion dollars at the end of 2022, a 100,000x return. Instead, perhaps the heart of the problem is one of misplaced attention. In investing, the natural tendency is to focus on the question of what to buy or sell. Nearly 100% of the financial press is dedicated to this question, so it's reasonable to suppose that the “what” decision is the most important thing we should be thinking about. It isn't.

We'll explain that the most important financial decisions you need to get right are of the “how much” variety. How much should you buy of a good investment; how much should you spend today and over time; how much tax should you defer to the future; how much should you spend to insure against low probability, high consequence events. Implicit in these questions is the recognition that risk is present in just about every good thing we come across. So, whenever we're trying to figure out how much of a good but risky thing we should do, we need to weigh the greater expected benefit from doing more versus the cost of taking more risk. We hope to leave you with a practical framework for making these sizing and risk‐taking decisions consistently and confidently.

Why do we think sizing is so important? Consider this: if you pick bad investments but do a good job sizing them, you should expect to lose money, but your losses won't be ruinous. You'll be able to regroup and invest another day. On the other hand, if you pick great investments but commit way too much to them, you can easily go broke from normal ups and downs while waiting for things to pan out.

Our own personal experience backs up the proposition that the sizing decision, often an afterthought, is actually the most critical part of investing. We've both experienced first‐hand the impact of getting the “how much” decision wrong, losing the majority of our personal wealth in the process. Victor was a founding partner at the hedge fund Long‐Term Capital Management (LTCM). In 1998, at age 36, he took a nine‐figure hit when LTCM was undone by that decade's second financial crisis. The monetary loss was compounded by the psychological blow of the business’ failure and its impact on the 153 employees who worked there, as well as the impact on the reputations of all involved. A decade later, James at 28 lost a smaller sum but still a material fraction of his wealth in part through his investments in the hedge fund where he worked.

In each case, we believed we'd selected investments with an attractive risk/reward profile that were highly likely to pay off in the long run. The trades that took down LTCM in 1998 were money‐makers over the ensuing years, and the hedge fund that employed James also bounced back to generate strong returns following its precipitous swoon in 2008. Unfortunately, the short run always comes before the long run, and neither of us got to enjoy the rebound of these investments. The lesson: good investments plus bad sizing can result in cataclysmic losses.

The LTCM story has been told countless times—several books, many articles, and even a Harvard Business School case study. It was colorful, involving Wall Street traders straight off the pages of Michael Lewis’ Liar's Poker together with a band of highly respected professors, including two Nobel Laureates. To the outside world, it appeared that they had built a money machine (one of the books about LTCM was rather hyperbolically titled Inventing Money), so it's not surprising that most of the LTCM partners were heavily invested in the fund they managed. The fund had returned more than 40% per year from inception to shortly before its decline, with an annual volatility of about 12%. And prior to founding LTCM, the older partners could look back on their 20 years of very positive experience doing the same kind of investing at Salomon Brothers.

Victor had about 80% of his family's liquid wealth invested in the LTCM hedge fund. With the benefit of hindsight, this level of investment concentration was a mistake. But the more useful question to ask, which hasn't been addressed anywhere in the LTCM literature, is this: what analysis should Victor have done to determine how much to invest in the fund, and what would that analysis have said? We'll provide a detailed answer, and we'll also show why “as much as you can get” is almost never the correct answer to the question “how much of a good thing is right for you?”

Is this poor sizing judgment confined to the likes of your authors when they were young, highly confident bond arbitrage traders, and to wealthy families living in the first half of the twentieth century? Unfortunately, there's quite a bit of evidence that this failing is more widespread and persistent, suggesting that investors are systematically hurt by poor money management skills. For example, individual investors in aggregate severely underperform market returns, in both absolute and risk‐adjusted terms. Some of this underperformance comes from paying high fees, but much arises from having too much or too little at risk and usually at just the wrong times. A landmark study of individual brokerage accounts by University of California Professors Brad Barber and Terrance Odean, aptly titled, “Trading Can Be Hazardous to Your Wealth,” found that individuals who actively traded their portfolios underperformed market returns by 6% per annum. Other researchers have found that the aggregate returns that investors in mutual funds experience are typically several percentage points per year below the returns that a buy and hold investor in those same funds would have earned.1

In an attempt to better understand how people deal with the sizing of attractive investment opportunities, Victor and his co‐researcher Richard Dewey conducted an experiment in 2013 that was later published in the Journal of Portfolio Management. In a controlled setting, they invited 61 financially and quantitatively trained individuals to play a simple coin‐flipping game. The participants were informed that the (virtual) coin was programmed to have a 60% chance of landing on heads. They were each given $25 and allowed to bet any way they wanted. They were told that at the end of 30 minutes—time enough for about 300 flips—they'd be paid however much the $25 had turned into, subject to a maximum payout of $250.

As we'll discuss in more detail throughout the book, there are a range of simple, sensible betting strategies that would result in an expected payout in the vicinity of the $250 cap.c So, how did the players do? More than 30% of them lost money, and incredibly, over 25% went bust! Only 20% made it to $250, a far cry from the more than 90% who should have. Our thesis in this book is that the ideas leading to doing well in our coin‐flipping game are equally helpful in making good decisions on the important financial matters in our lives.

Investing isn't the only area where making sound financial decisions under uncertainty is important. Everyone needs a coherent saving and spending plan for all stages of life, especially if they expect to enjoy periods of retirement. Even when it comes to the seemingly simple decision of at what age to start taking Social Security benefits, a recent study found that Americans are leaving more than a trillion dollars on the table by making suboptimal decisions, primarily by taking the benefits sooner than they should.2 There's also good evidence that many people spend too much on certain kinds of insurance, from protection on their kitchen appliances to comprehensive car insurance, while spending too little on other types of insurance products, such as annuities. Sadly, personal finance books just don't provide enough good advice either, as documented in a recent easy‐to‐read survey of the 50 most popular ones by Yale Professor James Choi.3

The decision‐making problems we focus on have three common features:

They require a decision to be made in the face of uncertain outcomes.

Some of the outcomes will have a meaningful impact on your happiness or welfare.

The impact on your welfare will not exactly mirror the monetary outcomes.

Philosophers, economists, and mathematicians have been thinking about how to systematically evaluate these kinds of decisions for almost 300 years, since Daniel Bernoulli introduced the concept of a “utility function” in order to provisionally solve the St. Petersburg Paradox, which we describe in Chapter 6. It's virtually a law of human nature that we experience a diminishing marginal benefit from further and further increases in spending (or wealth). This is why the utility we derive from spending our wealth doesn't mirror the monetary sums involved. Thinking this way makes it clear that we should make decisions that maximize our utility rather than purely monetary outcomes. These ideas are at the root of economic thought and permeate even through the younger branches of the economics tree, such as behavioral finance.

The utility‐based decision framework has at its core three main steps for any given financial decision. First, we need to assess possible monetary outcomes and estimate their associated probabilities. Then we need to map these monetary outcomes into utility outcomes. Finally, we need to search over the range of different possible decisions, to find the one which produces the highest Expected Utility.

The framework of maximizing Expected Utility is the foundation of the field known as “decision‐making under uncertainty” as well as most other theories of individual choice and human interaction. Many of the ideas that form the basis of this book are found in the sub‐field known as “lifetime consumption and portfolio choice,” an area first formulated and explored in the 1960s by Nobel Prize‐winning economists Paul Samuelson and Robert C. Merton. The basic problem addressed is to determine the choices that a person should make with regard to investing, saving, and spending that will maximize Expected Lifetime Utility.

Unfortunately, many of the original papers in this field have been too complex or abstract to gain traction in practice, with the result that very few people are using these tools to make better decisions. In the pages that follow, we hope to present these important ideas in a way that will not only resonate, but also change your thinking. It can take a surprisingly long time for a great idea to make the jump from theory to practice; we believe these are great ideas whose time has come.

The framework of making decisions to maximize Expected Utility has been criticized for not being a realistic representation of how people actually behave. Indeed, researchers have documented myriad cognitive biases that result in inconsistent and irrational decision‐making. We agree with this evidence wholeheartedly, and that's exactly why we've decided to write this book—in order to help people make better decisions by understanding what happened to all those missing billionaires and overcoming some of those cognitive biases! No framework would be needed if people were naturally