Several months ago I completed a week-long classroom program at the University of Chicago’s Booth Business School, as preparation for the Certified Private Wealth Advisor (CPWA®) designation, which I received in April. The CPWA® program focuses less on investment strategy, and more on issues of asset protection and wealth transfer, than did the Certified Investment Management Analyst (CIMA®) program I completed at the Wharton School years ago. (Both of these designations are issued by the Investment Management Consultants Association.)
The program helped to clarify my thinking about a key issue for successful people from many different professional and entrepreneurial backgrounds—the skills and strategies needed to acquire or accumulate walk-away wealth can be very different from those needed to protect it, transfer it, and use it to produce lifetime cash flow.
Consider the owner of a successful business. That business owner can use retirement plans and investments to accumulate financial net worth, but in most cases the core asset she owns will be her business. Research suggests that a typical business owner, at the moment she sells her business and walks away, has over 80% of her net worth in just two assets—the business itself, and the equity in her home.
Here’s the problem. Once that business is sold, the owner needs to figure out what to do with the proceeds. Success in business typically requires the management of concentrated risk; in a small business, you succeed by going narrow and deep. You focus on one product or one marketplace, develop superior solutions for your customers, and get paid really well for doing so. The essential question you must continuously answer is, “How can I develop and maintain my advantage in creating value in my narrow and specific market niche?”
Imagine a successful entrepreneur sells her business, realizing enough after-tax wealth to confidently provide income for as long as she lives. What should she do with that wealth? There are two potential answers with very different potential results:
To understand the distinction, let me tell you a story about a former client, who I’ll call Joe. (Not his real name.)
When Joe came to us, he had just received a several-million-dollar lump sum, which was enough to provide his desired cash flow for as long as he lived, based on conservative assumptions. He began working with us at the tail end of the tech crash, so prices were attractive and potential returns high.
We invested Joe’s money in a diversified portfolio, leaving $1 million un-invested so he could pursue some real estate investment opportunities he’d identified.
Over the next five years, Joe invested in one real estate project after another, funding the investments by liquidations from his securities portfolio. After the first two years we began, with increasing urgency and energy, to counsel against further real estate investments. His answer was always similar: “I’m going to get paid 15% on the money I’m lending on this property deal, once they sell it to a developer.” In every case, Joe believed he was making an investment superior to those available in the public securities markets.
I’ll cut to the chase. Joe lost everything—all of his various real estate investments, his non-retirement investment portfolio, even his house. He ended up net in debt, even after the liquidation of every cash asset.
Joe made two fundamental mistakes. First, he concentrated all of his risk in one asset class—residential real estate in a single suburban market. Second, he made decisions based on projections and trailing returns, not on current price and potential cash flow.
More broadly, Joe’s error was in choosing to maximize returns instead of managing risks. During my week at Chicago Booth Business School, I heard one story after another of clients similar to Joe—individuals and families who had accumulated enough wealth for a lifetime, usually by selling a successful, family-owned business, only to lose most or all of it by continuing to pursue market-beating returns in concentrated-risk strategies.
What’s the alternative? A simple, three-step process:
What if you already have more than enough money to fund your cash flow needs? If so, you should determine what part of your portfolio is needed to hit your number and put it aside. Then you can safely do whatever you want with the rest. Become a venture capitalist or a philanthropist, play the ponies, or cruise around the world. But whatever you do, never mix the two pools of assets again.
There is more to this story, especially around how to legally structure ownership of your pool of capital to protect it from litigation and other non-investment risks, but the place to start is by knowing your number, and asking yourself—and your advisors—the right questions.
By James S. Hemphill, CFP®, CIMA®, CPWA®/ Managing Director & Chief Investment Strategist
Jim has been a CERTIFIED FINANCIAL PLANNER™ professional since 1982. Jim specializes in complex wealth transfer and retirement transition strategies and coordinates TGS Financial’s investment research initiatives.
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