A THEORY FOR BUILDING WEALTH
NTRODUCTION
The following idea is completely made up by me. It’s a practice that Warren Buffett took advantage of, yet I never see others talk about it. The rumors that Warren became wealthy as a stock picker are true… but only in part. The more important element of the wealth equation (his included) is discussed here.
To start, I propose the literature out there for how to build wealth is mostly flawed and self-serving. The individuals who write that information have an ax to grind, and most often the result is taking money out of your pocket and putting it into theirs. If you would like to know my feelings on financial advisors and the state of financial advising, you can get a taste for it here.
One of the pinnacles of modern financial theory is called “portfolio allocation”. I’m sure many of you have seen this in some form or fashion. If it isn’t ringing any bells - just think “Pie Chart”. The pie chart is a great selling tool for folks in finance. It’s always adapted to fit their narrative, built to depict some “model” portfolio informing you how to allocate your dollars for the maximum return. Pie charts can range anywhere from proposed sector allocations in a single investment account, to overall net worth allocation between public equities and alternative assets. It all depends on what the advisor is trying to sell.
I’m not one to bury the lead, so I’ll tell you my ‘bright idea’ right here in the introduction. A pyramid. That’s all. My world shattering new theory for building wealth throws out the pie chart, and replaces it with a pyramid. It doesn’t take a lot of imagination to make that up, so I can’t pretend I’m some kind of genius. All I’m saying is that the subtle difference between the two is what separates the high net worth individuals in my network from the standard income earners hoping they have enough saved for retirement. And as a side note, I think financial advisory emphasis on special types of accounts, like tax deferred or Roth accounts, is an admission that they have no idea what they are doing. Theories of wealth creation should not focus on average investment returns with alpha generation via slick tax evasion strategies.
THE WEALTH PYRAMID
There are a few core tenants behind the wealth pyramid: 1.) cash flow is king, and 2.) patience. As Warren Buffett once said “you can’t have a baby in one month by getting nine women pregnant”. Great things take time. If you rush into building wealth you will set yourself up for major disaster down the road. Respect the Pyramid.
Each level is described in more detail below. The purpose of each level is to generate sufficient income to make investments in the level above it, with increasing investment risk characteristics as you approach the peak.
Base
Obviously the base of the Pyramid is the most important. It’s your income. One could argue that income is a shaky base. But it is completely under your control. It’s the act of trading your energy and time in return for money. Do it as long as you possibly can. The base is strong as long as you live frugally. Don’t waste your income on accessories or luxuries - no status symbols. Your income should go towards those things necessary to maintain your survival. Any excess income over and above that goes to the purchase Level 1 assets. Note: if you want to purchase a business, the income from that business is included in the Base level of the pyramid if, and only if, you are involved in the day-to-day operations of the business. There is a difference between investing and “buying a job”.
Level 1 Assets
Let’s pretend you’re hyper disciplined and capable of following the theory “by the book”. In that case, all of the marginal income from your pyramid base finds its way to Level 1 assets. These are extremely low risk assets like treasury bonds, CDs or debt-free real estate or real estate equivalents (like royalty interest) - only if they generate cash. Level 1 assets are meant to be as close to risk free as possible, while continuing to generate new income for further investments. Never leverage Level 1 assets. Own them outright and hold on to them forever.
Level 2 Assets
Level 2 assets should only be funded by cash generated by Level 1. Level 2 assets can be made up of low risk dividend stock, convertible notes or preferred shares paying a cash interest, corporate debt, or leveraged real estate/real estate equivalents. Level 2 assets can also include small business purchases where you are hands-off in the day-to-day business, not acting as the key manager. The purpose of Level 2 is to take a little more investment risk in return for higher cash flows. This is where the ‘investing’ decisions start.
Level 3 Assets
Level 3 is where things get interesting. This is the top of your pyramid. Level 3 is for the “home-runs”. The high risk high reward investments that show little or no potential cash flow, but have a very high upside. The nuance to Level 3 assets is that they can be purchased in two ways: 1.) through Level 2 asset cash flow 2.) by leveraging against Level 2 asset equity. Level 3 assets include highly leveraged real estate; limited partner interest in VC, PE, real estate syndications, or small business search funds; high risk growth stocks; and other alternative assets meeting ‘high risk/high reward’ investment criteria.
ANALYSIS:
The purpose of the pyramid is to keep an individual compounding their wealth without risking a full scale blow up. As long as the Level 1 assets are always growing, there will always be opportunities to rebuild from loss. After a lifetime of work, the Level 1 assets should generate enough cash flow to sustain you through the later years in life even as your base income goes away. You should NEVER take leverage against Level 1 assets, and the only leverage against your base level income should be for those things necessary to live (car and home). For Level 2, it is ok to leverage against those assets to purchase higher risk investments, but you run the risk of losing them when a Level 3 investment doesn’t work out the way you hoped.
Why is this pyramid important?
I’ve been practicing investing for a long time now. With many shots on goal I have developed a practical framework for how the game works, learning a lot from my losses. The fact that I’m still here is a small victory. Here is what I know from experience; some (like Buffett) claim that their biggest losses are the acts of omission, but for investors today that’s not quite the truth - their biggest losses come from switching allocation. The biggest problem for an investor today is that it is easy to find a good investment, almost too easy. Making it hard to wait for any one investment to fully play out.
Many investors allocate a certain amount of money to a specific portfolio or investment thesis (remember that pie chart?) and they expect it to be self-sustaining. Not only that, they expect it to outperform. That mindset plants the seed for a future conundrum… opportunity costs. When a set amount of capital is fully invested, investors are forced to sell out of one good position in order to buy into another. And in typical fashion, the old investment will finally make a significant jump in value right after they exit, while the new investment will sink lower for no reason at all. THIS HAPPENS TO EVERYONE. It’s normal.
The Wealth Pyramid is built to avoid the sticky opportunity cost debacle for an investor. As long as the base and Level 1 assets are in place, new cash flow will constantly be available for new opportunities. When you don’t have to sell an old position to pay for a new one, you feel better about the portfolio as a whole. You’re now in the game of consistently accumulating many positions, rather than hoping to pick the best one on your first try. You’re also able to be patient and wait for the upside of older ideas. The pyramid is about training patience while alleviating the psychological struggle caused by choosing one investment over the other.
I believe investing like this will generate the most wealth over the long-term in a sustainable way that can be carried on for generations. Many believe Warren Buffet became wealthy by investing in stocks. In part that’s the truth. The real trick to Warren’s success is his belief that you should never sell a good investment - we all know his motto is to buy and hold forever. The only reason he was able to do that over the long-term is because of the constant cash flow that came from the insurance business at Berkshire. Warren always had new cash coming in the door to take advantage of newer opportunities, and he rarely had to sell good investments to chase after other good investments. He was working with a pyramid while everyone else played with pie charts. Something we should all strive for.
Cheers,
B.