Amassing generational family wealth often takes years of discipline, planning, and sacrifice. Yet, it is widely reported that 70% of families who have the attributes needed to build wealth will lose it all by the second generation (fortune recommends, Dec. 14, 2022).
How could this happen?
No two families are the same. Naturally, families have a variety of quantitative and qualitative differences that dictate how decisions are made for the benefit of the family and future generations. However, all families face similar challenges in managing their wealth and creating legacies. And, all families need processes in place to control emotions and mitigate drama while making family decisions. Without these backstops, families put themselves at risk of making a number of common mistakes.
This primer is an overview of the risks associated with common issues high-net-worth (HNW) families face and how to navigate them.
Educating the next generation on how to manage wealth is the most critical aspect of leaving a multi-generational legacy, making the lack of financial education the biggest risk to the family. It is estimated that 70% of families lose their wealth by the second generation and 90% by the third. Clients need to be forward-thinking about how to build knowledge around financial education within the family, what topics to discuss and when, how to spend money, how to invest, and how to make financial decisions.
Particularly after a year like 2022, it is not a secret how volatile public market can be. Over the last ten years, S&P Index Proxy (SPY) has returned +12.16% per year with a 14.81% standard deviation. When constructing a portfolio, I believe in utilizing a version of modern portfolio theory (MPT). Developed by Harry Markowitz in the 1950s, MPT is a mathematical framework used to weigh the exposure within the portfolio such that the expected return is maximized for the given level of risk. I prefer to partner with top-tier investment managers across all asset classes, but MPT works with core satellite approaches as well (more passive core exposure) if implemented correctly. The key is understanding the risk you are taking within the markets and ensuring you are getting the maximum return possible for that level of risk. All public market portfolios should be supported by back-testing and scenario analysis for potential crises.
In addition, families who hope to perform well investing in public markets should have a rebalancing process. Markets are efficient, meaning they digest information quickly and reflect an opinion of a sum of all the data, but at times, the degree of efficiency can oscillate, causing dislocations. Families who have an unemotional rebalancing process can take advantage of those dislocations and compound significant wealth over time.
HNW families are usually involved in private markets to some extent, either through a family-owned business or by being invested in private equity, hedge funds or other alternative investments. Generally, alternative investments can offer diversification and balance the risk of a public market portfolio, but they are usually more expensive and illiquid, and it can be challenging to understand the risks associated with the investment.
In many instances, a family business created most of the family’s wealth. Often, families know their business extremely well but have challenges diversifying their wealth away from the family business because the family business is all they have ever known. I always say, ‘trade what you know,’ meaning it is okay to utilize the knowledge from your specific industry or expertise, but one can easily become overexposed to risks specific to it. Being realistic about the risk of the family business in current and future economic backdrops is vital to a family’s legacy. Establishing a process in which the family makes business and investment decisions will help reduce associated risks and set the foundation for decision making as the family evolves.
The concepts highlighted thus far also pertain to a family’s real estate portfolio. Real estate can be an uncorrelated asset in a family’s overall portfolio, providing tax-advantaged income and diversification from other asset classes, and it is less volatile than most other investments.
That said, a family should look to build their real estate portfolio with an understanding of the associated risks with each property and location. All properties inherently have different factors that affect the income they produce, possible appreciation, and general risks. Families get comfortable with one location or one type of property, such as industrial buildings or student housing, usually because they get comfortable with a real estate sponsor in a specific location or who has specific industry expertise.
A real estate portfolio should be diversified across regions, with different demographics supporting the properties. The portfolio should have a diversity of stabilized, improvement and development projects. A family should create a process around vetting new real estate sponsors and doing their own due diligence on the projects. The family should have a vision of what the real estate portfolio should look like and understand any idiosyncratic risks to their strategy.
“Risk varies inversely with knowledge.”
A HNW family will naturally encounter various challenges and opportunities. It is paramount to have the right team (either internally or externally) to navigate them intelligently. Understanding your advisors’ backgrounds, experience, and expertise is vital to how and when a family leverages them. An experienced advisor can help you quickly conceptualize risk and recognize the intrinsic value of an opportunity. Your family should build a circle of advisors with different expertise to help with various projects and situations that your family will ultimately experience.