Size Matters
I read a fascinating book by Victor Hagani recently, the Missing Billionaires. Victor was a successful trader in Solomon Brothers and subsequently was one of the founders of Long Term Capital Management (“LTCM”).
LTCM was set up by several highly successful traders from Solomon Brothers including some Nobel Prize winners such as Myron Scholes (of Black Scholes Model fame) and Bob Merton. LTCM was initially very successful with returns of 31% per annum over the first 4 years. However, for a range of reasons LTCM failed spectacularly in 1998 due to unforeseen international events (including a Russian Debt default) and was rescued by a range of banks. Interestingly, LTCM made a small net profit over its life, but the founders lost all their investment in the fund.
In his book Hagani talks about how in the US in 1900 there were 4,000 millionaires. If we take these millionaires and use assumptions around spending, investing, taxes and these millionaires passing on wealth to their heirs, he projected that there should be circa 16,000 billionaires in the US today (yes billionaires – with a B). However, there are approximately 720 billionaires (Forbes list 2022) in the US and only 20% of these (circa 144) can trace their wealth back to 1900, hence the term missing billionaires. One of the reasons for this massive wealth destruction comes down to sizing (having concentrated investments that, when they decline, cause a catastrophic impact on wealth due to their size in the overall asset portfolio).
Hagani discusses how when he joined LTCM he put 50 years of living expenses in Treasury Bonds (with the balance being 80% of his wealth in LTCM) which seems very sensible. However, he notes that if he were to look at it again today (Hagani is a now successful financial advisor running his own firm in the US), he would have looked to reduce his exposure in LTCM to a lower level. As Hagani says “Critically, I should have included my ownership in the management company as a large part, more than 50 per cent, of my total assets. It was risky, and more importantly, a large loss in the fund would likely wipe out its value and put a big dent in my ‘human capital’ too. If I had used a framework that explicitly modelled my personal risk aversion and applied it to my entire balance sheet, I think I would have decided to put about 50 per cent of my liquid capital in the fund, rather than the 80 per cent I did invest”
How does this apply to regular investors? Well, we often meet new clients with single stock risk (usually a large stock position built up from employer stock compensation). In a lot of cases, these clients work for the firm they hold the stock in (they now have financial capital risk and human capital risk). Our advice in these cases is usually to sell the stock and buy the broad market and/ or repay debt.
Similar rules on sizing can apply to a business you own. Should you take money off the table to reduce risk and secure your financial future or retain the full risk? Whilst it is a personal decision, in most cases reducing the risk (and future potential return) makes sense. In Ireland in recent years, private equity has played a role in allowing business owners to take some money off the table.
Overall, investors should be considering their entire portfolio and their level of risk aversion when making investment decisions. These decisions should be aligned to a financial plan which is based on your personal and financial goals and objectives. A Warren Buffett quote comes to mind “Don’t risk what you have and need, for what you don’t have and don’t need”.