How to make a fortune

The Forbes 400 list of richest Americans came out recently (you can see it here).

I enjoy looking through the list each year (and have for 20) to better understand how people become wealthy. We are not talking about the mass affluent, the affluent, high net worth, or even ultra high net worth, here. We are talking about billionaires. The highest on the list is at $81 billion and the lowest is at $1.55 billion. These people haven't just become wealthy, they have become fabulously so. How?

That's the question I ask myself each year, and this year I decided to keep track.

I wasn't interested in finding out how many inherited wealth. Inheritance does not create wealth. With this in mind, I kept track of how the Forbes 400 made their fortunes.

One category is entrepreneurship. These are people who come up with an idea and then put it to work by starting their own company. The Forbes 400 is dominated by these folks at 52% of the list. Some did it through technology, others through retail, some with restaurants, some with medical devices and pharmaceutical products. These people create the new products and services we all enjoy. They had to be smart and hard working to succeed, but also had some good luck. Think Bill Gates, Larry Ellison, Sam Walton, Michael Bloomberg, Mark Zuckerberg, Larry Page and Sergey Brin. Not only do the dominate the list as a whole, they dominate the highest rungs of the list.

Next are the business fortunes, clocking in at 20%. These are people who instead of starting companies, either worked at businesses or bought businesses from others and put themselves in charge. Looking over the list, I see that they frequently fix broken businesses or make okay businesses great. Think Steve Ballmer at Microsoft, the Koch brothers, Rupert Murdoch, Richard Kinder, George Kaiser and Meg Whitman.

Next are the investing fortunes, coming in at 19%. These are people who don't start or run businesses, per se, but invest others and their own in such businesses. They may influence the businesses, but they don't run them. In some cases, they are completely separate from the business. This can be done through a holding company, with a hedge fund, through private equity, or running money through mutual funds. Think Warren Buffett, Carl Icahn, George Soros, Len Blavatnik, Ray Dalio, Ron Perelman, John Paulson and James Simons. 

Next are the real estate fortunes, coming in at 9%. These fortunes were built by buying real estate--usually with leverage--and rolling the dollars made back into more real estate. These fortunes are high risk/high reward because of the leverage usually required, but also require smart business moves and an understanding of where and how real estate will succeed. Many Americans, I think, over-estimate how successful this strategy is. The list includes names like Donald Bren, Andrew Beal, Stephen Ross, Richard LeFrakand and Leonard Stern.

I was surprised to see there is a lawyer on the list: 1. So, being a lawyer comes in at 0.3%. Way to go Joe Jamail: The King of Torts.

There you have it. Entrepreneurs top the list. You can make a massive fortune by finding an unmet market need and meeting it through hard work, long hours, and a good piece of luck. Or, you can be a successful businessperson joining the right company at the right time or by fixing broken or sub-par businesses. Or, you can invest other people's money through lots of research and a knack for understanding when markets become irrational. Or, you buy and sell real estate with a lot of debt, some good luck, and a keen sense of location, location, location.

Or, you can be the King of Torts.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

You choose: short term "reward" and long term risk, or short term "risk" and long term reward

 

Whether they want to or not, investors face a basic choice: some options will allow you to achieve your goals, and others won't. To reach your financial destination, you can either:

• get lower returns and save more money over time (thus having less to spend )
• get higher returns and save less money over time (thus having more to spend)

There's no option to save less and get low returns--that won't work.

The difficulty investors face is that they want to take little or no "risk"--avoiding anything unpopular or seemingly scary. But, what if the avoidance of supposed risk prevents you from reaching your goals?

A beautiful drive in the country can be pleasant, but if it doesn't your destination, then it's the wrong route. You can make valid choices among routes that will get you where you want to go, but you can't successfully ignore whether the route will get you there.

With investing, you need to clearly understand your options, you must flesh-out the pro's and con's of each, and then you must choose your path.

Right now, investors face a fundamental choice between risk and reward. On the one hand, you can choose options that will likely do well in the short run and terribly in the long run. On the other hand, you can choose options that will will likely look unrewarding in the short run, but ultimately be much more rewarding in the long run. The choice is between: 

• cash (including checking, savings, CDs, etc.)
• bonds
• commodities
• stocks
• real estate

Cash and bonds will likely do well in the short run and be an unmitigated disaster over the long run. Cash and bonds have done well over the last 30 years as inflation and interest rates have gone from mid-double-digits in the early 1980's to low-single-digits now. This process simply cannot repeat (going from 2% inflation to -11% inflation?). This means cash and bonds may look good in the short term, but will almost certainly provide terrible returns over the long run. To choose cash and bonds, you must either be able to perfectly time the point when inflation and interest rates change direction, or you will not reach your financial goals.

Commodities are likely to do well in the short to intermediate term, but then drop like a rock at some indeterminate point in the future. Commodities have done very well over the last 12 years and are likely to continue to do so over the next 5 to 10 years. In the not-too-distant future, though, they will fall off a cliff and provide investors with very poor long term returns. Any observation of long term (inflation adjusted) commodity prices will make this abundantly clear. Like with bonds, commodities will go from great to terrible very quickly, and unless you can time that switch perfectly, you will not reach your financial goals.

Another option is stocks. Stocks have done poorly over the last 12 years, and are likely to provide unexciting returns over the next 5 to 10 years. The outlook beyond that, though, is bright indeed, with 10%+ average returns. The problem is that very few investors are willing to look beyond the short term--or their wished-for ability to time the market--to reap the much better long term results from stocks.  

The last option is real estate. Real estate has had a dreadful 6 years, and is obviously an unpopular place to invest right now. The returns from real estate are likely to be much better than cash, bonds and commodities over the long term, but the short term looks unenticing. Real estate is another choice with little short term upside, but good long term reward.  

To me, the choices seem clear. Cash, bonds and commodities provide short term "reward" with significant long term risk, and stocks and real estate provide short term "risk" with real long term reward. If you want to reach your goals, and don't suffer from the delusion you can time the market, then stocks and real estate are clearly the best options.

If your financial plan permits lower returns, real estate is likely to be a less bumpy ride. If you require or desire higher returns--and the vast majority of people do--then stocks are the best option.  Choose wisely.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.