You must have heard the saying, “Don’t put all your eggs in one basket.” But the richest investor in the world, Warren Buffett, says, “Put all your eggs in one basket and watch the basket very carefully.” Wonder why?
Look at anyone who’s really rich – Bill Gates, Mark Zuckerberg, Steve Jobs, etc. How did they get there? Hint – it’s not by investing in a diversified portfolio of mutual funds. No, they got rich by starting a business. In fact, the biggest source of self-made wealth in the Forbes 400 list is business across a range of industries.
There are numerous articles on the sources of wealth for those on the Forbes list, yet two popular misconceptions remain about the wealthiest one percent of Americans – that they were either born into wealth or that they mainly include the CEOs of the largest public companies.
Both of these are wrong. A recent study titled Family, Education, and Sources of Wealth Among the Richest Americans, 1982-2012 states, “The Forbes 400 of today also are those who were able to access education while young and apply their skills to the most scalable industries: technology, finance, and mass retail.” It also showed that CEO salaries, even at their peak, are small change compared to the average compensation of the highest-paid hedge fund managers.
Importance of focus/concentration and leverage/scale
If you really study the rich, you will notice the common thread is that they tend to narrow their focus, usually to something they are good at, and then leverage that skill or competitive advantage.
Leverage could be positional such as social leverage, or it could be financial, as in borrowing. Leverage can amplify both gains and losses, so the user has to be pretty confident.
Where to focus and leverage
So, what risks can you take to get rich? Here is a rundown of some of the ways you can make super returns:
- Starting a business – As mentioned before, most people on the billionaire list have made their money by starting a business, or growing the business they inherited. A business is really the only way to be productive. If you look carefully, all other investments are based on somebody’s business. It may appear easy because of the success stories, but the statistics are sobering. Most startups fail. It takes a combination of people, ideas, execution, market timing, etc.
- Real estate – You can buy property in a location that is about to or is undergoing change such as new infrastructure, or is being re-zoned. The property could be a piece of land, or an old building; the appreciation is more likely to come from its location rather than the building itself. The risk of buying one property (obviously in one location) is that something could happen to the property, or the location, or for that matter, the tenant.
- Alternative investments like private equity and hedge funds – Private equity is investing in unlisted companies. It can give high returns partly because the companies invested in tend to be smaller and therefore earlier in their life cycle, and partly because they are unlisted and therefore their valuations are arbitrary. The real returns come only from exits, i.e. when companies are sold or listed on the stock exchange. The risk comes from the fact that a lot of smaller companies don’t end up making it big, so the investments have to be “written off.” On the other hand, hedge funds claim to be able to make high returns from listed markets based on the fund manager’s skill or “proprietary” (i.e. secret) formula, but a big part of the high return is the high leverage. To protect their secret formula, hedge funds lack transparency, hence could get into a lot of trouble before investors find out.
- Futures and option trading – Futures and options have inbuilt leverage in that you are able to get exposure to a bigger portfolio by putting in a small amount. However, like any other leverage, it can go both ways – both your upside and downside is magnified.
- Employee stock options – ESOPs have made a lot of people rich; the trick is to pick your employer well. In fact you really have to be careful because your salary and portfolio is exposed to the same one company.
But ensure you have a solid foundation
So why does every adviser tell you that concentration and leverage are bad, and advise you to build a diversified portfolio rather than huge risks?
While you might hear about some people who put their last dollar into starting a business and succeeded, remember you only hear about the ones who succeeded. For everyone who did, there are probably 100 who didn’t. They don’t get written about. So while it’s good to learn from the success stories, it’s prudent to put some thought into building wealth.
My “Build wealth like you build a house” framework allows you to do that. In summary, my suggestions are:
- Build a foundation of emergency cash and insurance
- Add some pillars of growth assets
- Put in a slab of passive income
Then you can have fun trying to be the next Warren Buffett or Mark Zuckerberg by taking huge risks.