Letter to a friend who just made a lot of money

These thoughts were prompted by a question from a friend who had just made a lot of money. But as I crafted them, I realized that the habits of mind he’d need to cultivate to manage his own good fortune also apply to other circumstances.

Quieting your own ego to see clearly your own strengths and weaknesses, assessing what areas other people are highly credible on and then giving them the decision space to execute, designing your system to be anti-fragile — all are skills that improve your odds of success in any field or endeavor.

Dear John,

Congratulations on your exit. You asked me how to think about it all, so here are some initial thoughts.

1 — Take your time and design an anti-fragile system

It’s important to have a background assumption that there’s no hurry. Sit on cash as a default. The stock market could be going vertical right now, it could be plunging. What the market is doing is irrelevant. What your friends are doing is irrelevant.

As Charlie Munger says, “the idea of caring that someone is making money faster than you are is one of the deadly sins. Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?”

When we manage capital for wealthy families, we sit on cash all the time. Don’t get on the envy trolley; sit in cash and enjoy it.

While you do, read some good books. One book on wealth management I often recommend is The Aspirational Investor, by Ashvin Chhabra. Ashvin was head of an endowment, wrote the book while serving as CIO of Merrill Lynch Wealth Management, and today oversees a hedge fund manager’s family office (he’s a doctor’s doctor in that respect). I find him highly credible on this set of topics.

Nassim Taleb’s works also have a lot of signal in them, even if his writing style makes it tricky to find at times. Here Taleb is on the benefits of cash and a “barbell” strategy:

If you put 90 percent of your funds in boring cash and 10 percent in very risky, maximally risky, securities, you cannot possibly lose more than 10 percent, while you are exposed to massive upside. Someone with 100 percent in so-called “medium” risk securities has a risk of total “ruin from the miscomputation of risks. This barbell technique remedies the problem that risks of rare events are incomputable and fragile to estimation error; here the financial barbell has a maximum known loss. For antifragility is the combination of aggressiveness plus paranoia — clip your downside, protect yourself from extreme harm, and let the upside, the positive Black Swans, take care of itself.

Design an anti-fragile system for you, your family, and your money. Taleb has a great quick test for anti-fragility: If you have more to lose than to benefit from events of fate, there is an asymmetry, and not a good one…You are fragile.

2Identify what you’re good at and how you’re going to use that strength

Our founding client, the CEO of a large home builder, is fond of saying that it’s common for people to make money like professionals and then invest it like amateurs. Warren Buffett says that if you don’t know who the dumb money at the poker table is, you’re the dumb money. In order to avoid being the amateur or the dumb money, I would first try to establish what you and people who know you well believe you have a lot of credibility in doing.

For one wealthy family I know, that meant that they reserved 5% of the total assets for one family member to invest in art. For another, who was a doctor, they reserved up to 10% to pursue health care related investments. Others give 100% of it to an in-house or out-sourced chief investment officer (CIO). When you eventually become a father and are debating whether to let one of your kids have the money to invest, start them off with a small amount of decision space (a small amount of capital) and then see how they do objectively.  Having relatives invest your capital without earning the credibility in the markets or private business arena first will only make for tense Thanksgiving meals and lousy returns.  More generally, I have come to believe that any non-meritocratic allocations of capital dials up the fragility in the system.

General Stan McChrystal, who together with his chief of staff, Chris Fussell, led the U.S. military’s Joint Special Operations Command, observed that their job in running all of the special forces units in Afghanistan was to assess the various team captains’ credibility and then give them the appropriate amount of “decision space” based on that assessment. To allocate decision space they used a basic formula: credibility = proven competence plus relationships plus integrity.

I see the task of managing a pool of one family’s or foundation’s capital as essentially that same exercise — assess people’s credibility on a given activity, and then give them the appropriate amount of decision space based on that assessment.

What you need to do is assess your own credibility and that of potential partners, and then decide how to divide up the decision space over your capital. It’s important to take your own ego out of it and assess your own comparative advantage with clear eyes. Warren Buffett gave his entire savings to the Bill and Melinda Gates Foundation to manage his charitable giving; he had a quiet ego and saw that they could do it better than he could ever realistically do himself. Bill Gates owns a ton of Berkshire Hathaway because he knows that Buffett is much more credible on making investments than Gates will ever be himself.

Yet even as you divide up the decision space, you need to remember that no piece of it should ever be shared — one person owns each discrete decision space. Chris Fussell stresses that, in order for this structure to work, leaders and, in the special forces, “operators” must have a shared understanding of accountability and autonomy. In the special operations community, the most effective leader sends an implicit but clear message to the forces operating under him:

I understand the complexity of the environment. I understand that you must move faster than our structures allow for and that you understand your problems better than I ever could. I will create spaces for you to organically communicate and share information. I will empower you to make decisions and execute. I can help guide us on the path, but only you can win the war. I trust you to do that.

This is the kind of message you should try to send to the people investing on your behalf, whether that’s an outsourced CIO, an internal CIO of your family office, or a set of teams that you try to recruit. If you don’t trust the people to manage your money, sit in cash; if you do, give them the money and follow an “eyes on, hands off” policy.

The no-man’s land, which we see people fall into all the time, is where the capital owner wants to have one foot on the playing field and one foot off, suggesting ideas to the manager of the capital without having to execute them. That puts the manager in a uniquely bad position: if they pursue the investment and it doesn’t work, they get the blame; if it does work, the owner gets the credit. Several prominent family offices have gone through way too many CIOs to count because of this dynamic; now no one credible will ever again take the job because they correctly realize that it’s a “tails you win, heads I lose” proposition. (And it’s already hard enough to get the best investors to work for you, since they know that they can usually make more on their own or as a partner in another firm than they will working for another principal.)

In Fussell’s description, the operator offers an implicit response back to the leader (or principal):

We understand that you’re building us the space to thrive but that it is ultimately our journey to take. We see you humbling yourself to the reality of the complex fight. We trust you to protect our ability to move with speed and adaptability. We will rise to the challenge and hold ourselves accountable to the outcome.

This message is remarkably similar to what the best performing investment managers communicate to their sources of capital and what we hope our clients hear from us. The bottom line is that giving your team captains both autonomy and accountability is critical.

3 — Figure out how you’re going to build trust with your manager

Assessing credibility and building trust is a skill, and it’s learnable. Just like a start-up CEO, who has to hire an engineer or sales person without necessarily being good at that role themselves, you need to get a good hiring process in place.

I have a question I ask candidates when I’m hiring them for a skill set I don’t have: “if you were going to hire someone to do this, what criteria would you use?” The answer is often wildly different for apparently similar people with similar backgrounds and reveals what they believe to be critical based on their experience.

When it comes to a CIO to manage your capital, I would answer that question with the following criteria:

A) Someone who can provide evidence that they have good “taste” in people; has an ability to assess other people’s credibility and give them the appropriate amount of decision space; and attracts the top talent by exuding an attitude of abundance about fees and opportunities, an implicit message of “let’s compound our capital together”

B) Someone with a “quiet” ego who is pragmatically focused on making money for you (and themselves, assuming they have incentive compensation), not on scoring style or status points or constantly proving to you how smart they are — as Taleb puts it, deep down they want to win, not win an argument

C) Someone who is conservative by nature; hates losing money with a passion but, paradoxically, can still take “good” risks; and has that unusual mix of aggression and paranoia

I’ll close with Taleb’s observation that the stoic Seneca understood that success has the potential to make you fragile:

When you become rich, the pain of losing your fortune exceeds the emotional gain of getting additional wealth, so you start living under continuous emotional threat. A rich person becomes trapped by belongings that take control of him, degrading his sleep at night, raising the serum concentration of his stress hormones, diminishing his sense of humor, perhaps even causing hair to grow on the tip of his nose and similar ailments. Seneca fathomed that possessions make us worry about downside, thus acting as a punishment as we depend on them. Even more: dependence on circumstances — rather, the emotions that arise from circumstances — induces a form of slavery.

I meet a lot of rich people and many of them are what Taleb and Seneca might describe as surprisingly fragile — the events of fate pose more downside than upside for them. Don’t let your new fortune make you fragile!