Five Common Pitfalls of Wealthy Families

“He remembered poor Julian…and how he had started a story once that began, ‘The very rich are different from you and me.’ And how someone had said to Julian, ‘Yes, they have more money.”

By Scott Welch, CIMA®, Chief Investment Officer & Partner

Reviewed by Carter Mecham, CMA®, IACCP®

This quote was Ernest Hemingway’s somewhat acerbic response to the much more famous passage from F. Scott Fitzgerald’s The Great Gatsby. But “Papa” was on to something. The rich may possess tremendous wealth, influence, and power, but they remain human, and therefore subject to many of the same mistakes the rest of us mortals make – especially when it comes to managing their wealth.

At the same time, the financial services industry is exploding with firms catering to “HNW” (high-net-worth) and “UHNW” (ultra-high-net-worth) families. Private banks, brokerage firms, independent advisors – the choices are almost endless, and all claim to offer a unique and differentiated solution to the needs of the ultra-affluent.

What is fascinating is that many wealthy families – and the advisors who serve them – make many of the same mistakes over and over again. The difference between a good advisor and a poor one frequently is based on the degree to which they can help their families avoid these common mistakes – and avoid making their own.

This article summarizes five of the most common pitfalls confronting wealthy families based on observations and anecdotes gathered over two decades of working closely with them.

Pitfall # 1: Paging Dr. Freud

One of the most fascinating fields of study in wealth management today is behavioral finance. Simply put, it is the study of why otherwise perfectly rational investors frequently make seemingly irrational decisions with respect to their wealth.

A highly accessible discussion of behavioral finance can be found in Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich. This book describes many of the typical errors of judgment made by investors and offers suggestions as to how to correct these errors.

In summary, the behavioral tendencies that drive irrational investment decisions can be captured under the concepts of either heuristics or prospect theory.

Heuristics Theory

Heuristics refers to “rules of thumb” decision-making that may or may not be based in mathematical reality. 

Representativeness

Have you ever made a decision because you thought you had identified a pattern or trend where none actually existed? Then you may be guilty of representativeness.

The typical example used to illustrate this concept is the so-called “hot hand” theory, whereby many sports fans assume that players can get “hot” when, statistically, they are no more likely to make their next shot or get a hit than their overall shooting percentage or batting average dictates.

In investment management, this frequently manifests itself in behavior referred to as “chasing the hot dot.” Many investors switch from currently under-performing managers to managers showing the best recent performance, regardless of the fact that historical performance is not at all predictive of future results as today’s “hot” managers frequently become tomorrow’s dogs.

Overconfidence

Do you consider yourself, relative to the general population, to be “above average” (a concept captured beautifully by Garrison Keillor in his Lake Wobegon stories)? If so, you may be guilty of overconfidence – the tendency to overestimate your ability relative to everyone else’s.

A simple example illustrates this point. The next time you are sitting with a group of friends, ask everyone who believes themselves to be an above average driver to raise their hands. Chances are everyone in the group will raise their hand – which of course is statistically improbable (if not impossible).

With respect to investing, overconfidence may lead to an inflated belief as to your ability to predict the future, which can lead to attempts to “time” changes in the market. The research shows overwhelmingly that “market timers” almost always end up under-performing a more disciplined investment strategy, especially once fees and taxes are factored in.

A different manifestation of overconfidence may be the usually ill-founded belief that you, as an investor, are better at identifying good investment opportunities than everyone else who has access to the exact same pool of information. In most cases, you will be wrong.

Anchoring

Another common heuristic behavior is anchoring – the tendency for people to establish a value scale (e.g. trading range, growth trend) based on recent performance. It also refers to the idea of making a decision based on an irrelevant fact or figure. 

“My stock’s all-time high was $75, so once it gets there again, I’ll sell.” The fact that the stock reached $75 once is, of course, completely irrelevant to where it might go in the future, but once the investor “anchors” on a certain price, all future decisions are likely to be influenced by where the market price is relative to that anchor price. Many investors over the years watched a significant portion of their net worth get wiped out while waiting for a price level or market value on an investment that, sadly, never came.

Gambler’s Fallacy

Suppose you were watching someone flip a coin, and the flip turned up “heads” nine times in a row. What are the odds that the next coin flip will come up “tails”? If you answered anything other than “50/50”, then you may be under the influence of the gambler’s fallacy.

This is, to some degree, the opposite of representativeness, since it refers to investors’ tendency to believe that they can predict when trends will reverse themselves. In our simple example of the coin flip, of course the odds on any coin flip are 50/50, regardless of what has happened previously. Like overconfidence, this can cause investors to attempt to time the market – a no-win proposition.

Availability Bias

It is well-known to wealth advisors that most Americans have most of their investments in US-based securities or managers. Likewise, most Europeans have much of their wealth invested in European companies or managers. We know intuitively that both sets of investors can’t be right in terms of optimizing their portfolios, so what is going on?

Nothing more than home town or availability bias – the process of giving too much weight to only the information that is readily available, rather than recognizing that this may only be a fraction of the story. Thus, US investors invest primarily in US securities because the information on those securities is more readily available, when, in fact, a truly diversified portfolio for most investors should include at least some allocation to international and/or emerging markets assets.

This is sometimes referred to as “familiarity breeds investment,” regardless of what the unemotional math says is appropriate.

Prospect Theory

The second primary concept within behavioral finance is known as Prospect Theory, which examines the fact that investors tend to (a) evaluate gains and losses very differently, and (b) view money (which is, of course, completely fungible) very differently depending on where they have “placed” that money in their emotional psyche.

Loss Aversion

As a typical example, consider loss aversion, or the very common tendency to place a much larger emphasis on losses than on equivalent gains. In other words, the prospect of losing $1,000 causes, for many investors, far more “mental pain” than a $1,000 gain results in “mental pleasure”. This can cause investors to forgo possible strategies that may be perfectly valid for their investment objectives.

Regret Aversion

Very few people, especially when it comes to investing, like to admit that they have made a mistake. This very natural tendency can lead to regret aversion, that is, investors taking actions (or not taking actions) to minimize the risk that they will feel regret for making the wrong decision.

A common example is holding on to an investment after the investment has lost significant value (or vice versa). Selling the investment crystallizes the loss, which causes regret – whereas if they don’t sell, the loss is not yet “real”. Conversely, many investors will hang on to their winners because of the fear that they may sell and then watch the stock continue to run.

Mental Accounting

Raise your hand if you have ever maintained a running balance on a credit card while holding enough cash in a checking or money-market account to pay off that debt. If you raised your hand (and most readers will), you may be guilty of mental accounting, the name given to the propensity for investors to compartmentalize their money by placing it in different mental “buckets”. Rather than examining their portfolios as a whole, they make decisions in pieces, when in fact each marginal decision affects the entire portfolio.

In this simple example, there is no economic reason to carry high-cost credit card debt if you have the cash to pay it off, especially if that cash is invested in low yielding assets – you are losing money every month in negative net interest.

Another very common example is for investors to focus too much attention on the performance of individual managers within their portfolio, rather than on the performance of the portfolio as a whole. The performance of any one manager will typically have only a marginal effect on the performance of the overall portfolio, but many investors focus on this because it is easy to track and, if the manager does well, easy to talk about with friends. 

What really matters, of course, is how well the overall portfolio does – how much money did you start with, how much are you worth now, and are you meeting your financial objectives? 

Still another common example might be investors believing they have achieved diversification because their money is managed by multiple advisors, when in fact there may be significant overlap in the actual investments of those advisors.

There are other aspects to behavioral finance that can lead to irrational investment decisions. The key is for the investor to recognize that these decision factors exist and can lead to making very bad investment decisions.

This is one area where the use of an unbiased, “emotionally detached” advisor can be of particular assistance. Good advisors will make suggestions that are valid from a quantitative asset allocation perspective but also fit comfortably within (but hopefully avoid the pitfalls of) whatever mental and emotional framework the investor has developed.

Pitfall # 2: “A tisket, a tasket, I have all my eggs in one basket”

Many affluent families created their wealth through entrepreneurial endeavors – they started companies and then sold them, frequently for stock in another company. Other investors created huge fortunes through the exercising of stock options in high-flying growth companies. Or, perhaps, they inherited the stock in an estate transfer.

Each of these examples may result in a different emotional frame of reference with respect to their stock holding, but the net result is the same – these investors have too much of their wealth concentrated in a single position.

A common adage in wealth management is “You get rich by being concentrated, but you stay rich by diversifying.” The problem is that too many investors focus on the first part of that adage and ignore the second. 

There are many reasons investors hold on to concentrated stock positions. Sometimes it is pure greed – the stock made them rich, but they want to be richer. Sometimes it is pure fear – frequently the fear of (or at least aversion to) paying taxes on their gains, or the fear that the stock will continue to run up after they sell. 

Other times it is ego – “XYZ bought my company (for stock), therefore XYZ must be a great company.” Oftentimes it is simply a case of inertia – “Hey, the stock has treated me well and I see no reason to change.” And still other times it is simply overconfidence – “I know, I know…all those other stocks cratered, but let me explain to you why MY stock is different.”

Regardless of why these investors hold their concentrated stock positions, the bottom line is that they are taking unwarranted risk. When investing in any given stock, investors bear three fundamental types of risk: (a) overall market risk, (b) industry specific risk, and (c) security specific risk. Study after study demonstrates that (a) investors have the ability to mitigate or minimize everything except market risk through prudent diversification, and (b) the market does not (over the long term) reward investors for taking risk that can be diversified away.

In other words, when investors hold too much of their wealth in concentrated holdings, they are not adequately rewarded for the additional risk they are taking. This issue is exacerbated by the fact that investors tend to (a) focus only on return and ignore risk, and (b) be very risk tolerant when their stock is going up but extremely risk averse when their stock is going down (paging Dr. Freud, again).

The problem is intensified by mass media stories of entrepreneurs and investors who “struck it rich” or who have proven to actually be successful stock pickers (e.g. Warren Buffett). Of course, we rarely read about the thousands of investors who lost fortunes by not diversifying appropriately.

Perhaps more accurately, the fact that thousands of investors did lose fortunes over the years was attributed to “corporate greed” or “accounting scandals” than it was to the fact that many of these investors simply had not appropriately diversified their investments and learned the hard way that there is no such thing as huge return without huge risk.

The truth, of course, is that if it were easy to pick stocks as successfully as Warren Buffett, he would not be so exceptional. An analogous example is winning the lottery – it is noteworthy primarily because the odds are so against any single individual winning.

The problem is also compounded by the natural tendency of individual investors to “brag” about their successful investments while conveniently ignoring their losses. All of this can lead to irrational expectations about “getting rich” – just make the right picks and watch ‘em run! Or, as was attributed to Will Rogers, “It’s easy to get rich in the stock market. Just buy stocks, and after they go up, sell them. If they don’t go up, don’t buy them.”

The reality is that there is no non-emotional reason to have more than 5% – 10% of a family’s net worth tied up in a single stock (excluding privately-held operating companies where there may not be any easy way to diversify).

There are a multitude of financial and charitable strategies available for diversifying away from concentrated holdings, and families would be well-served to educate themselves on those strategies – before their basket slips and all their eggs break.

Pitfall # 3: Penny Wise but Pound Foolish

The smart consumer always does comparative shopping. When buying a car, it makes perfect sense to investigate the prices at multiple dealerships. The car is the same at each location, but you never know when you’ll find a dealer looking to make a sale through lower prices or a better financing plan. 

The same concept applies to selecting a wealth advisor, right? Well, sort of.

The problem is that a car is a car – you can be reasonably certain that there will not be significant differences in a given style of automobile from dealership to dealership. But this is simply not true in the world of wealth management.

There are, obviously, certain financial products and services that are largely commoditized (loan rates, CD rates, etc.) and, in these cases, comparative shopping is perfectly appropriate.

But most ultra-affluent families have complex needs that go well beyond any commoditized product list, and yet many of these families base their wealth advisory decisions on cost rather than value.

One reason for this, frequently, is simply that the families don’t know what they don’t know – they have not yet identified the need for specific services or solutions and are therefore reluctant to pay for those services.

There is a great deal of competitive pressure on fees in the wealth management arena, and this places a certain cap on what any firm can charge before pricing itself out of the market. 

But if two wealth advisors are offering what sounds to be similar solutions, and one advisor’s price is substantially less, then (a) the service offerings are not similar, but probably significantly different, (b) the “cheaper” advisor may be making money in other ways (that perhaps have not been disclosed to the client), or (c) the “cheaper” advisor is losing money, and will not last long in the business.

In this regard, wealth management is not unlike the residential contracting business – buyers are wise to be cautious about simply jumping at the lowest bid.

Rather than shop for a low-priced provider, the affluent family is better served by engaging in some critical self-examination and determining what suite of services they need to meet their wealth management objectives. Then, they should seek the wealth advisor that can service those needs and which price their services in line with the value being delivered.

Pitfall # 4: Just the Facts, Ma’am

There is a very good reason why surgeons are discouraged from operating on their own children or spouses – it is very difficult to stay emotionally uninvolved and make dispassionate decisions when dealing with family members.

Wealth carries many connotations and creates strong emotions toward that wealth. Unfortunately, this can lead to irrational investment decisions. This issue can be compounded if the investment decision-making process has been delegated to a family member, as is frequently the case in family offices. This is not to say that family members are incapable of managing the family wealth – only that it may be difficult for the family to make dispassionate evaluations of the decisions being made.

One of the key factors to managing wealth successfully is to remove the emotions from the equation – the numbers and results are what they are, whether the investor likes them or not.

Historically, this is an area where many wealth managers have fallen short in advising wealthy families. Frequently, advisors bring a strong technical bent to the table, and the decisions and recommendations are driven strictly “by the math.” While quantitatively sound, these recommendations may not resonate with investors who bring emotional decision criteria into the equation, no matter how hard they may try not to.

The more successful investors and advisors are those who recognize the need for an integrated approach – specifically, the integration of quantitative asset allocation and portfolio construction with the behavioral finance issue discussed earlier.

The goal is to create investment portfolios that stand up under technical and statistical scrutiny while at the same time fitting well within the emotional “comfort zone” the investor or family has established.

Pitfall # 5: Tripping over the Watermelons while Looking for the Seeds

When confronted with a seemingly overwhelming situation, it is typical for people to focus on smaller issues where they feel they have more control. This is frequently true with wealthy families, though not in a way they may recognize.

When managing an investment portfolio, the key is to optimize the risk/return ratio of that portfolio, right? Well, once again…sort of.

Most investors are familiar with the concept of asset allocation – that is, diversifying your portfolio across different asset classes and investment styles. And many wealthy families focus extensively on finding “the next best idea” with respect to investments, be it passive versus active management, hedge funds, the private markets, emerging markets, and so forth.

What many investors are far less familiar with, however, is the concept of asset location – the integration of proper estate planning with investment planning. This is not to suggest that wealthy families don’t engage in estate planning, but rather that there is significant room for improvement in recognizing the value that proper estate planning can play in maximizing a family’s portfolio value over the long term.

This is not necessarily the fault of the family – many estate planning attorneys have no particular expertise in investment management and, conversely, many wealth managers have only a moderate level of estate planning experience. Far too often, these two respective specialists operate with a “silo” mentality, producing non-integrated wealth and estate plans.

The truth is that proper estate planning, and the tax deferral and minimization that go along with it, has the potential to add far more value to the wealthy family than finding the “best” investment managers or the “optimal” portfolio.

Most fundamental investment theories focus on risk and return characteristics but ignore taxes. But the proper placement of different investments within different entities (tax-deferred accounts, FLPs, various trust structures) can optimize the after-tax – both estate and income – value of the portfolio to a degree not remotely obtainable by simply creating even the “perfect” investment portfolio.

Summary

In summary, wealthy families can avoid most or all of these common pitfalls by recognizing that the successful management of their wealth is like a three-legged stool. It is the appropriate understanding and integration of investment management, estate planning, and behavioral finance.

Put simply:

• The perfect investment portfolio inside the perfect estate plan that does not fall within the investor’s emotional comfort zone will not get implemented;
• The perfect investment portfolio that falls within the investor’s comfort zone but which has not been intelligently integrated in the family estate planning will likely be tax-inefficient; and
• A sub-optimal but emotionally comfortable investment plan within a well-executed estate plan will not maximize the long-term value of the portfolio.

It is only by successfully integrating all three aspects of the wealth plan that the family’s portfolio will be truly optimized, which, in turn, emphasizes the importance of working with wealth advisors that understand this comprehensive wealth management dynamic.

Given the frequency with which the mistakes discussed in this article are made by wealthy families, we have a ways to go. But the wealthy family that does incorporate these lessons into their wealth management plan will be “very different” indeed.