The Game

Shirtsleeves to shirtsleeves in three generations. The old American proverb. Behind it sits the famous research from the seventies: three generations is roughly how long it takes to waste the wealth a founder built.

But that is a misreading. The research does not say the wealth gets wasted. It says it is unlikely that a business survives three handovers. And handing down a business is something entirely different from handing down wealth.

Wealth survives longer. Substantially longer.

Set a bar. What actually raises the standard of living of the people in a family? They have somewhere to live. Their education is taken care of. They have health care. I am very lucky to come from a European country where two of those three things are "free." Nothing is free, of course. It is paid for through taxes. But elsewhere in the world they are often very expensive, especially for poor parents.

Once parents secure housing, education, and health care for their children, more money on top of that does not lift life satisfaction much. Everything above that, the children must win for themselves.

It is a high bar and a low one at the same time. For the rich, a given. For the poor, a dream. With the handover of a business, we are talking about sums an order of magnitude larger.

Why it does not last

Why only three generations? Because the probability of success in business is small. Most businesses do not prosper over the long run. Full stop.

The world evolves. Competition evolves. The outside environment changes. And the inside changes too. At the start of a business there is more energy and drive than at the end of a productive life. For the same business model to stay profitable across several generations, it has to change. That is the paradox. Then it is no longer the same.

The moment I change the business model, I am really founding a new business. I am exposed to the same odds of success and failure all over again. And the odds say: it will more likely fail.

An opportunity for the next generation? It cuts both ways. Whoever catches the right wave wins a market advantage. Whoever misses it disappears.

Every company ends one day. The question is not whether. The question is whether you will be standing there when it happens, or your children, and whether your whole fate will depend on it.

If I had to mark the most important sentence in this chapter, it would be this one.

Wealth and business are two different disciplines.

Being a shareholder and owning a stake is something entirely different from actively running the company. The law makes that distinction. A shareholder, by law, does not have to work. The reality of family firms makes no such distinction at all. Whoever holds a stake is expected to work hard.

Take a family where the father is the founder, plus a wife and two children. The inheritance ends in thirds. And it is very unlikely that all three will work an equal share. Whoever works a lot will want a bigger reward. Whoever works little feels entitled to a third of the profit, because they hold a third of the shares. Both are right by their own lights. Merit against entitlement. What is fair, everyone sees differently.

This is how it goes where I come from. First the couple's joint marital property is divided. The wife typically gets half. The rest is split between her and the two children. Most of it ends up with the wife, who knows little about the business and has no wish to run it. A precarious situation.

Then the state steps in. Shareholders' dividends are often taxed less than pay for active work. So the one who grinds away and takes a wage for it is hit twice. He pays more, and it feels unjust next to the passive shareholder who does nothing. For it to be neutral, it should not matter whether I take a share of profit or pay for work. It does.

And the last layer. The active shareholder has the upper hand, because he has the relationships. With customers, with employees, with the bank. A passive minority shareholder with no relationships is in a weak position, especially in a company with no duty to distribute profit. Owning one hundred percent of a company I never receive anything from is economically worthless. But even a small shareholder has access to information. With it, he can paralyze the other side. He can blow the whole thing to pieces and do the majority owner real damage. But he cannot build anything.

I know this myself. When I started, I would happily work sixteen hours a day. I would rather work than go off somewhere on a trip. Why waste time when I can build something that means something to me. But in time it changes. And if a business has at least two partners, one of them will always end up working less and the other more. A clash of two personalities is inevitable.

Lawyers can destroy a business in a dispute. They cannot build one either. There is nothing left but to come to terms. So someone has to be the smarter one. It has to be you.

A bet on a single number

So who do you hand it to?

Entrepreneurs are roughly ten percent of the population. The good ones, half of that. So to have a statistical hope of one good entrepreneurial child, you would need about twenty children. And even twenty is no guarantee. Small numbers do not behave like large ones.

Then a founder stands up and says: "I built a billion-crown company. But I want my grandson to take it to a hundred and fifty percent." That is a bet on a single number at the roulette table. I met him. He is the founder I answered in the second letter, my voice trembling.

And what does it do to the grandson? He is handed a task he is unlikely to fulfil. If he pulls it off, well, of course, that was expected of you. If he does not, you are useless. And the second outcome is many times more likely. Over the long run it will break him, and it will certainly break the family.

Historically this was solved by primogeniture. Not because the firstborn is the most capable. But because one line does not splinter the wealth. People multiply, two children per adult, and wealth crumbles down the branches exponentially. One line means the whole stays whole.

I read it like this: pass the wealth down one line, so it does not splinter. Pass the leadership of the business to the most capable. And the most capable does not have to be family. Most likely, they will not be.

But the children should try. If they try nothing, they will certainly fail. Nobody jumps into running a large company without experience and lands it on the first go. Expose them to real risk. Their own projects. Work anywhere but the family firm. The world will not go easy on them just because they are somebody's children.

And if they fail? Look at yourselves. How many times did something not work out for you? As an entrepreneur I allow myself an enormous number of mistakes. I would fire an employee for a tenth of them.

Investing is a different game

There is a limited set of ways to become rich. Business. Inheritance. Marriage. And that is the end of the list. The lottery is marginal. Employment clearly does not lead to wealth. And investing? Investing needs capital, which you first have to get somewhere. So business or inheritance again. Or an extremely well-paid job.

The problem begins the moment a successful entrepreneur decides he will be successful at investing too.

An entrepreneur is used to bending reality with his own work and the work of the people around him. The harder he works, the more the result moves. An investor does not move the market. He must, so to speak, surrender to what the market does. He cannot bend it in his favour.

And here comes the most counterintuitive thing an entrepreneur will ever meet: in investing, doing nothing is many times better than making random moves.

If I open a pub and do nothing, I can close it straight away. If I buy an index and do nothing, I will probably beat the man trying to sell at a good moment and buy at a better one.

The most successful investment portfolios, paradoxically, belonged to dead people. Nobody touched them.

This is completely different from business. A dead man's portfolio outperforms someone who actively works at it. In business the opposite holds. If you do not work at the business, the competition will overtake you for certain.

The illusion of control over something I do not control is terribly strong. Will it get better if I look at the chart more often? If I read more news? If I open more trades? In the short run I feel better. In the long run the result is worse.

An entrepreneur often becomes an angel investor. And then discovers that money which was so hard to earn is not hard at all to lose. Or he takes up active trading. Same result.

Trading is at best a zero-sum game. What one wins, another loses. And because I pay fees, in practice it is a negative-sum game. The more I trade, the more of my wealth is exposed to it.

Why do people do it? Because you can win. In the short run, like at roulette. And the green numbers give you the feeling you called it, that you are smarter than the rest.

Ask drivers which of them is above average. Eighty percent raise their hand. Among doctors, over ninety. Among academics, ninety-five. Among traders it will be about the same. The numbers do not add up.

Exceptions exist. Arbitrage. I hold information the market has not yet priced in, or there is an inefficiency in the market. Activist investing. I have enough force to replace a company's management or move how the market sees it. That can bring excess return. But beating the market consistently, over the long run, is something nobody manages.

What to play, then

A stock index. The S&P 500 works by quietly removing those who stop doing well and replacing them with those who do. It gathers companies that generate profit. A positive-sum game, the pie grows. But it is a bet on the American economy. There have been periods when the index took twenty years to reach a new peak. The alternative is a world index, or an index assembled by your own rules and rebalanced.

Real estate. It outlasts a business. Land that is farmed outlasts the building. But real estate does not move. War, politics, bad demographics in the wrong place. It does not happen often, but when it does, the consequences are terminal.

Lending money. Two conditions, or the game can tip into a negative-sum one. I lend for more than inflation, and I want security. With corporate bonds I am typically not a secured creditor. I stand in the queue behind the banks and their collateral. When it collapses, and indebted companies collapse first, I get almost nothing.

Rebalancing

I set a ratio. Say thirty percent in shares. When shares grow and reach fifty percent of the portfolio, I sell enough to bring them back to thirty, and with the money I buy whatever the portfolio is short of.

It looks like maintaining a ratio. But its real function is different: the system forces me to sell what is rising and buy what is not. Buy low, sell high. It sounds banal, but human nature does the exact opposite. I hold, I hold, and when it drops fifty percent, I sell in a panic.

Rebalancing also generates liquidity. And it does so exactly when I least feel like it. When everything is rising and I am sure it will keep rising. Then the shock comes, and I have something to buy with. When there is blood in the streets, that is the best time to buy.

The most important consideration in building a portfolio is not return. It is liquidity. How much money I actually need for my life and my ventures.

And leverage? You can borrow against shares quickly and cheaply. But leverage means a non-zero probability that the portfolio gets liquidated. And over a long enough period, a non-zero probability becomes a certainty. If the portfolio is to last forever, leverage must never be in it.

When to take money off the table

The only reason to sell anything is that the asset has stopped being productive, or is about to. The business will not be profitable. The property no longer earns rent.

And that is why a portfolio must never stand on one company. That company will, by definition, sooner or later stop earning.

Sell high. And keep the money ready for the next opportunity. The aim is not to win once. It is to still be at the table in the third generation. To play.

Michal Hanych