• Ashvin Chhabra
  • May 11, 2021
    Read, recorded or researched
Ashvin Chhabra runs Jim Simon's family office. Before that, he had been the CIO at Merril Lynch and at the Institute for Advanced Study. His book is really good. It offers a great overview of financial markets and how they work, and delivers a different way to think about your own portfolio and personal goals.

The Best Points

The Aspirational Investor

What do the investment strategies that yield great wealth have in common?

[Based on an analysis of individuals on the Forbes 400 list]

The answer is simple. At least initially, the paths to great fortunes are idiosyncratic strategies that involve monetizing brain power, knowledge, and expertise (that is, their own human capital and that of their employees) through the use of two potentially perilous elements: leverage and concentration (along with hard work and lots of luck, of course).

Concentration and leverage may also be present in a non-economic sense: for example, individuals may be able to leverage family access or derived a connection or benefit by virtue of political capital to belonging to a particular professional or social network.

The point is that the super-rich do not earn their wealth by building conventional portfolios based on the principles of asset allocation and diversification.

In fact, they do the opposite. All four primary sources of wealth creation represented in the Forbes 400 involve “idiosyncratic risk" - the kind of risk that, according to the tenets of modern portfolio theory, "rational" investors can and should eliminate by diversification.

Yet most of the people on the list believed, and still believe, that focusing on what they know best is the least risky strategy.

Imitating the investment strategies of the Forbes 400 is not for the faint of heart. Nor is it necessarily sensible. Making decisions based on success stories, while ignoring failures, is a common behavioral pitfall known as "survivor bias" and often leads to missteps and disappointment.  

Which brings us to another important point: the strategies for making wealth and keeping wealth are not necessarily one and the same. The struggle to keep a balance between creating and preserving wealth is a non-trivial one.

In fact, one of the most remarkable aspects of the Forbes 400 is its incredible volatility, in terms of both the enormous swings in wealth among those on the list and the fluidity with which people come and go from the list.

According to one analysis, only thirty-six individuals who made the original list in 1982 stayed rich enough, and stayed alive long enough, to qualify for the Forbes 400 for the next twenty-four consecutive years. Back then, 13 percent of the list came from just three families: eleven Hunts, fourteen Rockefellers, and twenty-eight du Ponts.

By 2002, these three families were down to just one, three, and zero members, respectively. Fast forward to 2010: Ray Lee Hunt, with $3.2 billion, ranked 62 and was the sole Hunt family member. David Rockefeller, with $2.4 billion, was ranked 132 and was the only Rockefeller. The lone reference to the du Ponts was an unfortunate one: a mere mention of John E. du Pont, who made the list from 1982 to 1987 and was dying while serving a life sentence for murder.

One of the most interesting studies of churn on the Forbes 400 was conducted in 2004 by my long-time colleague and research collaborator, Lex Zaharoff. This research was based on an extensive analysis of the reasons why people dropped off of the Forbes 400.

Consistent with the findings in Bernstein and Swan's All the Money in the World, Zaharoff and his team found that just 15 percent of the names, a mere fifty-four individuals, stayed on the list every year from 1982 to 2003.

Of the 346 names that were no longer on the list, the researchers determined that 141 individuals, or 36 percent, had dropped off due to non-risk reasons, such as the recalculation or reclassification of their wealth by Forbes or death and distribution of wealth to family members, foundations, and the taxman.

Of the remaining 205 dropouts, a majority, 59 percent, fell off the list because the wealth did not grow fast enough or there was an outright erosion of the wealth.

Zaharoff and his colleagues then analyzed the cause of each exit from the list and identified a combination of eight risk factors that played a role in each case. They are as follows:

  • Concentration
  • Leverage
  • Excessive spending
  • Taxes
  • Family dynamics
  • Liability
  • Currency
  • Government action

Interestingly, the first two factors on this list, the double-edged swords of concentration and leverage, are precisely the factors we identified earlier as the keys to earning your way into the Forbes 400.

The rest of these factors are simply additional risks that, for these individuals, could not or were not effectively mitigated and eventually caused the individual to lose excessive wealth relative to peers on the list.

Zaharoff concludes his report with a recommendation: that as individuals and families move from wealth creation to wealth preservation, they must shift the types of risks that they take.

The secret is finding the right balance among safety, growth, and investments with the potential to create significant wealth – and that may or may not involve leverage and concentration.

How much money do you need?

The sheer uncertainty of future equity market performance is an especially intractable problem in determining your Number. The recurrence of financial crises and the turbulent history of markets suggest that stock returns are not exactly dependable.

Equities should and historically have delivered positive real return, when averaged over long periods of time. But in the long run, as economist John Maynard Keynes famously said, we're all dead.

If your standard of living is dependent on the future performance of the stock market, then you must be able to absorb extreme losses and survive the stretches of time when there are no returns at all.

What you really need is a framework to achieve goals no matter what the market does: one that at least minimizes the impact of year-to-year market fluctuations on your probability your essential of success.

Using such a framework, the key to providing a satisfying answer to the question "Am I on track?" rests not on the unpredictability of financial markets but rather on how effectively you identify, prioritize, and quantify your goals and investment strategy appropriately along the way.

Your goals and aspirations seem so personal, and perhaps so idiosyncratic, that they may defy any attempt to create a general framework that would logically organize them, let alone build a wealth management strategy to achieve them. But the work of one of the stars of academic psychology, Abraham Maslow, helps point the way.

In the early 1950s, Maslow was pioneering a new approach to the study of human behavior. Instead of focusing on the mentally ill, as was the convention at the time, he studied "exemplary people" - the top 1 percent of achievers in various fields, such as contemporaries Albert Einstein and Eleanor Roosevelt.

Maslow's ground-breaking work, the basis of what is today called humanistic psychology, includes a breakdown of the psychological underpinnings of human aspirations. These are often illustrated in a famous pyramid known as Maslow's hierarchy of needs:

Source: The Aspirational Investor

Maslow's pyramid spans five categories that can be boiled down to three essentials: the need for food, shelter, and safety, that is, basic requirements for survival; the need for family, friendship, and intimacy, which creates a sense of belonging, love, and acceptance; and, at the top of the pyramid, a need for self-esteem and "self-actualization," defined as the ability to pursue your interests, which may include charity and service to others. As Maslow succinctly put it, "What a man can be, he must be."

At first glance, Maslow's hierarchy of needs may seem unrelated to the discipline of investing. But if you define risk as the failure to meet your needs (or goals), then the hierarchy of needs provides an elegantly straightforward way to think about how to order those goals and the consequences of falling short. Using Maslow's framework as inspiration, every investor can categorize and prioritize goals, as follows:

Essential goals:

  • Safety and shelter: the certainty of protection from anxiety or poverty. Risks include loss of employment, health issues, loss of life (as a risk to other family members), accidents, and so on.
  • In order to meet your essential goals, you must construct a safety net that protects you from the variety of risks listed above, including extreme market volatility. In other words, you must achieve a certain level of safety.

Important goals:

  • Thriving within a peer group: this enables and facilitates the process of nurturing and supporting those who are important to you, including a spouse, your family, and peers.
  • In order to meet your important goals, you must achieve a high probability of maintaining your current standard of living. In other words, you must achieve stability.

Aspirational goals:

  • A way to pursue your dreams and aspirations, including further education, starting or expanding a business, philanthropic giving, or other aspirational goals like travel.
  • In order to meet your aspirational goals, you may have to allocate capital to projects that may be viewed as uneconomical or to investments that, in adverse circumstances, may result in catastrophic losses. Your pursuit of aspirational goals must therefore be sized appropriately to recognize the possibility that the capital invested in such idiosyncratic endeavours may be completely lost.

The way to get a handle on your goals, then, is to make a list; categorize them as essential, important, and aspirational; and quantify the cost by deconstructing each one into a series of cash flows.

Saving for retirement isn't your only goal, of course. Other financial goals include saving for a child's college education, buying a new car, purchasing or maintaining a vacation home, or starting a business. Different people will categorize the same types of goals in different categories.

This prioritization depends on a variety of factors, such as your age, how much money you have relative to your needs, and the simple fact that one person's essentials may be another individual's aspirations.

Let's imagine that you have only one essential goal: Rather than turn to a retirement calculator and be led astray by potentially flawed assumptions, there is a simple alternative calculation for your Number that requires just a single, key assumption: that your investment return matches the rate of inflation.  

This assumption enables you to easily calculate in today's dollars what you will need in the future. It simplifies all of the calculations to a remarkable degree and also provides an important buffer against the negative effects of withdrawing money during market downturns.

An economist might call this approach "calculating in today's purchasing power" or "the constant purchasing power method." I call it the "zero discounting method" or "really simple retirement calculation."

Every number is reduced to what you need today, and thus everything is directly comparable in purchasing power. An additional benefit of using this approach is that if you or your financial advisor wants to be more aggressive or more conservative in your assumptions, you will be able to adjust the calculation in a single place, at the very end.

Nest egg required to retire today (in today’s dollars) = # of years in retirement x how much you spent over the past 12 months

The Wealth Allocation Framework

  • The certainty of protection from anxiety or poverty, or safety.
  • A high probability of maintaining your standard of living, or stability.
  • The possibility of achieving upward wealth mobility, and creating the potential to meet your aspirations.

These three seemingly straightforward objectives form the foundation of the Wealth Allocation Framework, an approach to managing wealth that combines modern portfolio theory's teachings on asset allocation and diversification with key insights from behavioral finance.

Most important, the Wealth Allocation Framework provides a pragmatic, multidimensional approach to managing risk in relation to your goals. In the Wealth Allocation Framework, risk management addresses both quantifiable risk within the Markowitz framework and true uncertainty as defined by Knight and Mandelbrot.

This process, called risk allocation, is achieved by creating three distinct risk buckets to support each of the corresponding three key objectives of your wealth management strategy. The risk buckets can be summarized as follows:

  • Personal Risk: You must protect yourself from the anxiety of a dramatic decrease in your standard of living. Thus, you must immunize yourself from personal risk: the devastating impact of not being able to meet your essential cash needs, regardless of the performance of financial markets.
  • Market Risk: You must maintain your lifestyle by earning a rate of return in the financial markets that is comparable to the increase in the cost of living. Thus, you will probably have to take on market risk. This is the risk, according to Markowitz, that cannot be diversified away through portfolio optimization.
  • Aspirational Risk: In order to create the possibility of wealth creation and wealth mobility, or to fulfill your aspirational goals, you may decide to allocate capital to investments or business ventures that involve idiosyncratic risk and the potential for substantial capital gain or loss.

Because of its diversified nature, the market risk bucket is about statistically quantifiable risk - the focus of Markowitz's pioneering work.

The safety and aspirational portfolios, on the other hand, are about the risk and opportunity of uncertain outcomes, the focus of Knight and Mandelbrot, among others.

In the Wealth Allocation Framework, risk allocation - that is, the allocation of your assets and liabilities among the three risk buckets - is more important than, and in fact must precede, both the selection of assets and the selection of investments and managers.

The Wealth Allocation Framework recognizes that there is no free lunch. Assets that provide safety and have the potential to hold their value in a market crash will not provide high return potential. Therefore, investments allocated to the personal risk bucket will be selected to limit the loss of wealth but will probably yield below market returns.

Allocations to the market risk bucket will provide risk-adjusted market returns, in accordance with the diversification principles of modern portfolio theory.

Finally, allocations to the aspirational risk bucket should be selected to yield above-market returns, but they will carry the risk of substantial loss of capital.

In this manner, each of the three core objectives of your wealth management strategy is assigned its own unique risk profile and requires its own carefully constructed portfolio: a safety portfolio consisting of protective assets; a market portfolio with the objective of stability for the long term; and an aspirational portfolio to help you generate wealth to achieve your aspirational goals.

Source: The Aspirational Investor

Asset allocation vs. Security Selection

The ongoing debate about the relative merits of active versus passive investment management plays out in other important ways. One fundamental and controversial framing of this issue centers on the relative importance, in driving portfolio returns, of asset allocation decisions versus the selection of individual securities.

In a ground-breaking 1986 paper that examined the performance of ninety-one large US pension plans over a ten-year period (1974 - 1983), authors Gary Brinson, L. Randolph Hood, and Gilbert Beebower found that "investment policy (asset allocation) dominates investment strategy (market timing and security selection), explaining on average 93.6 percent of the variation in total plan return."

These astounding findings, published in the influential Financial Analysts Journal, led professional investors, financial advisors, and investment committees to conclude that their time was best spent determining a target asset allocation for their institutions and clients, not picking stocks or managers.

However, decades later, the idea that asset allocation reigns supreme over security selection is a subject of ongoing debate. Still, two key takeaways are clear:

  • If your managers do not take big bets, then the alpha generated by your portfolio will be small and the return from market exposure (beta) will dominate. In addition, your portfolio's monthly performance will be highly correlated to the performance of your benchmark.
  • If you want alpha, you will need to find a few very good managers and allow them the freedom to take concentrated, contrarian bets. Conversely, if you hold a large number of similar strategies or constrain them on how much risk they can take, then your performance will approach that of the benchmark. Since active management is a zero-sum game, the active bets made by managers in aggregate tend to cancel each other out.

Notes on the Endowment Model

What exactly is the Endowment model? David Swensen's explanation of the endowment model, as outlined in his masterly book Pioneering Portfolio Management, emphasizes three key themes: a disciplined and well-thought-out investment process; "insightful implementation," with an emphasis on "avoiding or minimizing conflicts of interest that are present at every step of the investment process"; and "an understanding of what it takes to beat the market and the courage to stick to a contrarian but well-thought-out investing strategy."

Based on these three key principles, according to Swensen, the resulting portfolio:

  • is equity heavy, to capture the equity risk premium and generate, on average, higher rates of return than bonds. This allows the portfolio to preserve, over the long term, its purchasing power with regard to inflation and also peer institutions.
  • has a large component that is illiquid, to capture the illiquidity premium and thus take advantage of the very long-term investing horizon of the institution.
  • is largely devoted to active investment management, with managers afforded considerable freedom to use their expertise to invest across a variety of strategies and asset classes in order to exploit inefficiencies in the markets.
  • is characterized by investment terms and incentives that are structured to reduce or minimize conflicts of interest between investors and investment managers.
  • allows managers wide freedom on investment strategies and implementation of their strategies through customized investment vehicles. This means that many of the underlying investments in the portfolio may not be through public stock, mutual funds, or index funds, but through partnerships such as hedge funds or private equity vehicles.

For convenience and scalability, financial institutions and high net-worth investors that have tried to copy the Endowment model have lumped these non-traditional, illiquid strategies into a single sleeve commonly referred to as "alternative investments."

As the name suggests, these investments are considered "alternatives" to allocations to traditional asset classes such as cash, fixed income, and equity, even though they are often initially carved out of the traditional equity allocation.

While the recommended asset allocation of a wealthy investor often includes an allocation to alternative investments, the Yale and Harvard asset allocations that is, their "policy portfolios" - go much further.

Risks with the model

So what went wrong with the Endowment model of investing in 2008? One way to answer this question is to assess the Endowment model through the lens of the Wealth Allocation Framework.

Over time, all of these institutions began to substitute some of their asset-liability matching bond investments (safety) with alternative investments (market), based on the (incorrect) argument that the diversified nature of these investments reduced the risk of the overall portfolio, thus necessitating a smaller allocation to safety assets such as bonds.

On the eve of the global financial crisis the endowment portfolios of both Yale and Harvard were overweight in the market portfolio, with little to no allocation to the safety and aspirational portfolios.

This may seem surprising, given that investments such as hedge funds and private equity, which make up the bulk of the portfolios, are generally perceived to be aimed at producing outsized, aspirational returns. But remember that aspirational investments require alpha associated with human capital, coupled with leverage and concentration, to create substantial impact.

To better understand the hidden risks to this strategy, let's complete the risk allocation picture of Yale's 2008 endowment portfolio by adding liabilities to our framework. Private equity and real estate commitments are not outstanding loans but rather promissory notes for a line of credit to be invested in illiquid and distressed investments that, when restructured and liquidated at an opportune time, should provide a superior rate of return. A severe market crash creates a myriad of opportunities for a sophisticated investor with ready access to capital. Thus, if these commitments were called in rapidly, the key question was: How would the endowment meet its commitments?

This is where a prior simple scenario analysis would have proved illuminating. In the Endowment model, existing private equity and real estate investments pay distributions that can fund future commitments.

It is not unlike having a basket of high dividend-paying stocks and committing to invest in future ventures by assuming that you will fund them through the stock dividends. If you match your future commitments carefully with your anticipated dividends, all should go well. But in a major market dislocation or crash, things can go very wrong.

In reality, there are many mitigating circumstances – for example, noting that its clients are in a liquidity crunch, the private equity managers might not call all the capital due, thus reducing the draw. That is a tough assumption to make, for it pits the opportunity for the fund manager to make an outsized return in a distressed market against the desire for it to retain its large blue-chip clients for its future fund offerings.

The endowment’s parent institution could also leverage its credit rating to raise capital in the bond markets to cover shortfalls or it could tap alumni networks. But each alternative comes with its own costs.