Excellent post by Barry Ritholz discusses the traps awaiting rich investors or what he calls The Fallacy of Competency Transference:
Last week, Bloomberg caused a minor stir with their story on C/NET founder Halsey Minor (How Halsey Minor Blew Tech Fortune on Way to Bankruptcy):
“How do you sell the technology company you founded for $1.8 billion and five years later file for personal bankruptcy? For Halsey Minor, it may have been a fascination with houses, hotels, horses and art.”
This tale of foolishness and excess is worth discussing, if for no other reason it is strewn with lessons for others. Not just for dot com millionaires, but for anyone else who suddenly finds themselves with much more money [than] they had the prior year. This goes for professional athletes, entrepreneurs, actors, rock stars and lottery winners. Even those kids of baby boomers who find themselves with a minor inheritance can find lessons to learn from Halsey’s follies.
The key is recognizing that your new found wealth is not an ongoing revenue stream, but more typically reflects a one time (or short term) windfall.
Why is that? Because you never know what the future holds. Post IPO stock prices can falter, athletes suffer from career ending injuries, artists may be one hit wonders. An old Yiddish proverb states “Man plans and God laughs.”
How do you plan and not tickle the funny bone of major deities? Be aware of what I call The Fallacy of Competency Transference. This occurs when someone successful in one field jumps in to another and fails miserably. The most widely known example is Michael Jordan, the greatest basketball player the game has ever known, deciding he was also a baseball player. He was a .200 minor league hitter.
I have had repeated conversations with Medical Doctors about this: They are extremely intelligent accomplished people who often assume they can do well in markets. (After all, they conquered what I consider a much more challenging field of medicine).
The problem they run into is that competency transference. After 4 years of college (mostly focused on pre-med courses), they spend 4 years in Medical school; another year as an Interns, then as many as 8 years in Residency. Specialized fields may require training beyond residency, tacking on another 1-3 years. This process is at least 12, and as many as 20 years (if we include Board certification).
What I try to explain to these highly educated, highly intelligent people is that they absolutely can achieve the same success in markets that they have as medical professionals — they just have to put the requisite time in, immersing themselves in finance (like they did in medicine) for a decade or so. It is usually around this moment that the light bulb goes off, and the cause of prior mediocre performance becomes understood.
Which brings us back to Halsey Minor: Without the expertise, without putting the time in, without much more than capital, he jumped into 3 different fields he had little or no knowledge of:
1. He became an Angel Investor, pouring money into early-stage startups and incubators and other such technology investments that eventually cost him a huge chunk of capital;
2. He went on a mad shopping spree for real estate, high-end art and contemporary designer furniture, “investing” tens of millions of dollars;
3. He purchased an immense Virginia Plantation where he planned to raise racehorses;
All of these purchases were eventually unwound at a fraction of their original purchase price in order to pay off creditors.
Which leads us directly to a few rules about dealing with sudden wealth:
1. You must avoid the hubris and arrogance that often accompanies sudden wealth. (Becoming wealthier does not = acquiring more expertise);
2. Debt is a dangerous tool, especially in the hands of the naive;
3. Assets are not the same as income; wealth is not the same as cash flow; Spending is not the same as investing;
4. You best understand your own strengths and weaknesses; this includes emotional, intellectual as well as behavioral.
5. Experience teaches us that the belief “I’m rich, therefore I must be very smart” is a recipe for disaster when not backed up with actual knowledge in relevant fields.
There are many more rules we can derive from this tale of woe, but perhaps the single most important one is the importance of living within your means. This is true whether you have $500 in the bank or $500 million.
Insolvency occurs when your liabilities exceed your assets and cash flow, regardless of how many zeros are on either side of the balance sheet . . .
In investment banking the joke was: “How to make a small fortune? Start with a big one.”
I have witnessed numerous examples of this Fallacy of Competence over the years. In fact I would go so far as to say it is the single biggest factor in the destruction of capital. Just because you are a competent eye-surgeon, for example, doesn’t make you a good investor. You are likely to exhibit the same level of competence as an investor as you would if asked to perform eye-surgery in your freshman year at university.
And just because you are wealthy doesn’t make you competent. The ancient Greeks believed that hubris is followed by nemesis.
As Will Rogers said: “We are all ignorant — just on different subjects.”