How the rich stay rich

When it comes to investing, the wealthy can afford to take more risks than the rest of us

By , Guest blogger

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    In this file photo, a money changer shows some one-hundred U.S. dollar bills at an exchange booth in Tokyo. Bonner argues that investment strategies for the wealthy are risky and dynamic, rather than safe and conservative.
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We agreed to write a book on “family money,” that is, on how families get and keep their fortunes over generations. We are completely unqualified to write the book, because our family never had any money. Still, it is a fascinating subject…and the more we look into it, the more we write about it, the more we come to understand what it is all about. It is not about “safe, conservative” strategies. Instead, it is a manifesto for the most dynamic capitalism on the planet.

The rich are not like everybody else. They shouldn’t try to be. Most people don’t have any money. People who have money are different. If you want to have money, it stands to reason that you have to do things differently. It’s that simple. Especially if you want to have money for more than a single generation.

For example, everybody is trying to find the stock that will go up. They all want to be an alpha investor — the big man on campus who puts his money into Google when it opened for business…or the guy who bought Berkshire Hathaway back in the ’70s. That’s the whole game, they believe…seeking alpha.

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Alpha is what they call the above-market gains you can get by selecting the right stocks. But the trouble with alpha is that it is as unreliable as a teenage employee. You think you’ve got him all set…and he doesn’t show up for work. You choose one stock that goes up. Then, you choose two that don’t. And then you get a real nightmare stock…and you’re wiped out. Over the long run — by definition and observation — most alpha-seeking investors cannot beat the market averages.

But what choice do you have? You’re a typical investor. You’ve got 10 years to build up a small pile of savings into a retirement fund. You do your homework. You take your chances. You hope to get lucky.

If you did that for a long time, your successes and your failures would about balance themselves out. Sometimes you’ll beat the market. Sometimes the market will beat you. Provided you didn’t make any major mistakes. But you don’t have forever. You can’t get average, long-term performance. You don’t have long-term. You only get a piece of it…and you hope it will be the good piece.

A serious family, with a serious long-term wealth strategy, on the other hand, has to do something different. It knows that chasing alpha will give it only average returns over time. It knows that average, long-term returns are very small. It wants to do better than that. And it has time on its side. So, how can it do better? Not by chasing alpha at all. Instead, it goes after ‘beta.’

A beta strategy is completely different. Instead of trying to beat the market you make the market your friend. You don’t try to beat it; you just want to join it. And go along with it. But you need to be careful to choose which market you join. You want the market that will take you to your destination. And you need to get aboard at the right moment.

We’ve explored this before…how you could have multiplied your money 150 times just by making three simple investment decisions in the last 40 years. And two of the decisions were exactly the same! Note that these are not alpha chasing decisions. These are beta decisions, choosing which market you want to be in…and waiting until the best possible time to get in.

So let’s go back. You know how Richard Nixon cut the dollar’s link to gold in 1971? It didn’t take much imagination to see what would happen next. Inflation rates would probably increase…and they would inevitably drive up the price of gold.

So, imagine that you started with $10,000. And in the early ’70s — you had years of opportunity — you bought gold. Just to keep the math simple, we’ll say you paid about $50 an ounce.

By the end of the ’70s your gold was shooting over $500 an ounce. You made 10 times your money. You were not sure what would happen next, but you read the paper. Paul Volcker, head of the Federal Reserve, vowed to crush inflation. He seemed serious. And by the early ’80s…it was beginning to look like he might win his battle against rising consumer prices.

Again, you didn’t have to have a Ph.D. in economics to realize that falling inflation rates wouldn’t be good for gold. On the other hand, they’d be very good for stocks or bonds. So, you made your second decision. You sold the gold and put the money into the stock market. Gold rose over $800, but let’s say you locked in your sale at $500…a “10 bagger,” as they say. Again, you had plenty of time to make your move. The price of gold stayed over $500 from the end of 1979 until well into 1981.

The stock market took its sweet time too. But that’s the way beta investing goes. One decision. Lots of waiting. The Dow lollygagged around for five years after 1980 before it hit 1,500. So, let’s say you waited 5 years and bought at 1,500. Then, you waited again. Gradually, the Dow rose. And rose. And rose.

By the end of the ’90s, the Dow rose over 10,000. By January, 2000, it was over 11,000. Then, there were so many warning bells ringing you would have had to be deaf not to hear them. The Dow was up 1,000%. People were starting dot.com businesses with nothing. No business plans. No sales. No profits. They were making millions selling them to investors. Something had to give.

What should you have done? You should have made your third investment decision in 30 years. You should have sold stocks and bought gold again. Stocks were overbought. Gold was oversold. Adjusting for inflation, gold was down 80% to 90% from its ’80 high. Stocks were up 5 times, inflation adjusted, from their ’80 low.

If you’d done that you would have multiplied your money another 6 times. Your original $10,000 would have become $300,000. Then, in gold since 2000, you would have multiplied your money another 5 times — for $1, 500,000.

But let’s say you missed the clanging bells in 2000s. You just held your stocks. In fact, after a brief drop, they continued to go up. The Dow eventually rose over 15,000 — giving you a total of about $500,000 at the top. Not too shabby, right?

That’s what beta investing can do for you. That’s what the smart money, the old money, the family money does.

In any event, that’s what we try to do in our family office.

Regards,

Bill Bonner,
 for The Daily Reckoning

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