Want to make and keep generational wealth? Read this from Daniel Rasmussen in The Wall Street Journal, who writes:
After the spectacular blowup of his hedge fund in 1998, Victor Haghani spent years studying the question of controlling risk. In “The Missing Billionaires: A Guide to Better Financial Decisions,” he and James White offer a smart and sophisticated primer on quantitative risk-management techniques.
Today the authors are principals at Elm Wealth, a multibillion-dollar wealth-management practice. They argue forcefully for a broader adoption of the “Merton share,” named after the Nobel-winning economist Robert Merton: “The expected profit required from a gamble increases not with the size of the risk, but rather with the size of the risk squared,” the authors explain.
This intuition is unfamiliar to most on Wall Street, but the math is simple. Consider an investor whose portfolio returns 10% one month and then loses 10% the next month—despite an average return of 0, the investor has actually lost 1% of his starting investment. But if the same investor had experienced twice the volatility—a 20% gain and a 20% loss—he would have lost 4%. Though the average return stayed the same, twice the volatility meant four times the losses. This is called volatility drag—and the authors believe that understanding this concept is the first step towards preserving long-term capital.
Messrs. Haghani and White apply this formula to provide a framework for building complex portfolios and managing them over time. The math yields some surprising insights. For example, investment allocation to high-risk assets should remain constant with age. And the 60/40 portfolio is the right mix of stocks and bonds given the Merton share.
The title of “The Missing Billionaires” refers to the authors’ contention that understanding risk is what separates the great investors from the rest. “The wealthiest families of the past were not equipped to consistently make sensible investing and spending decisions,” the authors conclude. “If they had been, their billionaire descendants would vastly outnumber today’s newly minted variety.”
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