The Truth About Wealth

By Robert Frank

Who says the rich always get richer?

Despite heated rhetoric emanating from politicians and pundits, the top 1% is hardly a fixed group that enjoys consistent income gains. To the contrary, the wealthiest have become the most crash-prone group in our economy.

Illustration by M.K. Perker

The total income of the top 1%—or those earning more than $343,000 in 2009—fell by more than 30% from 2007, according to the most recent Internal Revenue Service data. By contrast, the average income of the bottom 90% fell less than 3% during the same period.

A November Federal Reserve study, meanwhile, found that a third of the people in the top 1% in 2007, as measured by wealth, were no longer in the top 1% in 2009.

The good news: Despite the turbulent new economics of wealth, there are safeguards that the rich and future rich can deploy to cushion the shocks and mitigate their risks.

The wealthiest have likely recouped some of their sunken fortunes since 2009, along with financial markets. Yet the latest wave of data points to an indisputable trend—we have entered the age of "High-Beta Wealth."

On Wall Street, "beta" measures volatility relative to the overall market; a beta of 1.0 signals alignment with the market. Technology and gambling stocks can have betas of 1.5 or more, since they tend to overshoot the market in cyclical ups and downs. Utilities, by contrast, both rise less and fall less than the overall market and usually have betas below 1.0.

The new rich have become the high-betas of our economy. With their dependence on financial markets, their leverage and their hyperspending, the top 1% have income swings that now are more than twice as high as those of the rest of the population.

A study by Jonathan A. Parker and Annette Vissing-Jorgensen of Northwestern University found that the beta of the top 1% nearly quadrupled between 1982 and 2007 to 2.39. The top 0.01% had a beta of 3.96, making even the riskiest tech stocks look safe by comparison. Economists and wealth managers say the betas of the rich have likely soared even higher in recent months as markets gyrated sharply.

"Being a high-beta in today's environment is different from being a high-beta in the '80s or even the '90s," says Craig Rawlins, president of Harris myCFO Investment Advisory Services, which serves wealthy families. "People are more susceptible to making bad decisions than they've ever been. There is higher risk in the marketplace today, with a lot more volatility."

Lee Hausner, a California-based psychologist who works with the ultrarich, has one client she calls "The Phoenix," a real-estate developer and investor who borrowed and spent heavily. He has surged and crashed twice over the past decade, reaching a net worth of $400 million, losing it, then hitting $200 million and losing it again.

"He's an impulsive risk-taker," she says. "He always lays everything on the line."

For risk-takers who want to get rich and stay rich, Ms. Hausner advises taking a step back every so often and evaluating important decisions rather than leaving them to impulse.

"Some of these people roll the dice and they get rich," she says. "But they have to realize that if they roll it again, the result may not come out as well. They need to stop themselves before they roll again, and deliberate."

Though the high-beta wealth trend has been growing for close to three decades, it has accelerated markedly in recent years—enough to pique the interest of some financial pros.

In 2003, private-banking chief Maria Elena Lagomasino set out to study why so many rich people she knew were blowing up. Entrepreneurs, tech tycoons, real-estate titans and even CEOs who were known for their money savvy would make millions one year and lose it the next.

"This question just fascinated me," says Ms. Lagomasino, CEO of Genspring Family Offices, a wealth-management firm based in Palm Beach Gardens, Fla. "How is it possible that people who are on top of the heap can fall so precipitously?"

Her report, called "Beating the Odds: Improving the 15% Probability of Staying Wealthy" and commissioned when she was chief executive of J.P. Morgan Private Bank, found that only 15% of the Forbes 400 stayed on the list over a 21-year period. (Deaths accounted for less than a third of the drop-offs.)

The report grouped the reasons into five main categories:

Overconcentration. The path to rapid riches for many of the wealthy involves betting big on a single company or asset class, whether it is a tech start-up, real-estate or gold. When those assets boom, the gains are huge. When values decline, they can take an entire fortune with them.

Leverage. Debt has become the rocket fuel for lifting the rich into another financial orbit, amplifying gains and magnifying losses. In recent years, the wealthy have been using more debt than ever to maximize their investment gains, expand their businesses and fund their lifestyles Yet unexpected changes in their businesses or incomes can turn manageable debt levels into wealth destroyers.

Spending. Even among the more-restrained wealthy, "some of these folks really don't have a clue how much they are spending," Ms. Lagomasino says. Many look at their paper net worth and assume they can afford that private jet or fourth home. Yet their spending often exceeds their cash flows and returns, leaving them one crisis away from a financial collapse.

The "toxic cocktail." The first three reasons are often linked, with the newly wealthy betting big and borrowing big on a business, then using their paper wealth to fund a large lifestyle. When these three factors unwind at the same time, often forcing the rich to sell at distressed prices, they can instantly destroy huge fortunes.

Family issues. These include divorce, inheritance battles and family-business disputes.

There also are macroeconomic reasons. Before the 1980s, wealth came largely from inheritance, oil and privately owned businesses—all fairly predictable and stable sources of money. After the 1980s, more large wealth came from the stock market.

Executives became wealthy from stock-based pay. Entrepreneurs got rich by starting and selling companies, either through initial public offerings or mergers. And Wall Street bankers, hedge-fund managers and private-equity chiefs made money from market bets.

So how can investors and entrepreneurs stay wealthy without becoming high-beta casualties?

Wealth managers, psychologists and financial advisers say the age of high-beta wealth requires new financial and psychological tools to make and preserve family fortunes.

Gregory Curtis, chairman of Greycourt & Co., a Pittsburgh-based wealth-management firm, works with old-money families, some of whom have preserved their fortunes for four or five generations. He says one secret to enduring wealth is for families to divide their fortunes into two buckets: the "spending" bucket and the "appreciation" bucket.

He said families should live almost entirely off the spending bucket, which should be filled with a diversified, liquid portfolio of dividend-paying stocks and bonds and cash equivalents.

The appreciation bucket can be mostly stock or an ownership stake in a company. This bucket also can contain hedge funds, bets on currencies and commodities, and other investments.

The important point is that families should never have to rely on the "appreciation" bucket to fund day-to-day expenses.

"The biggest risk we see is concentrated holdings," he says. "So we say, 'Your lifestyle should be supported entirely by a liquid portfolio.' Even if they lost everything in the appreciation bucket, they're still OK."

The high-beta rich often have more than half of their wealth in one asset, whether it is a company or a single stock. As a general rule, wealth managers tell clients to avoid having more than 20% to 30% of their wealth in a single asset.

Limiting debt also is critical to avoiding crashes. The debt load of the top 1% has tripled over the past 30 years. Experts say a family's debt shouldn't exceed 25% of its assets, even though few follow the rule.

Stephen Martiros, a Boston-based adviser to family offices, says wealthy families should secure credit lines with longer time horizons (think years instead of months) to help them cope with economic storms.

"The real question for the high-beta wealthy is, 'Can you weather a worst-case storm?'" he says. "You don't want to be in a position of being forced to sell an asset at the wrong time because of leverage. That's when you get into real trouble."

What about entrepreneurs? Those who launch companies and bet everything on their success are loath to cash out too soon. Based on Facebook's latest valuations, co-founder Mark Zuckerberg would have given up nearly $1 billion in future value for every percentage point of equity he might have sold in the name of diversification. That isn't to mention the negative signal it sends to shareholders.

Yet wealth managers suggest that the Zuckerbergs of the world should regularly sell off small chunks of their stock as soon as their companies go public—or even sooner. They may be losing some upside, but they are building a critical safety net in case of a fall.

Netflix CEO Reed Hastings, for instance, has regularly sold shares of Netflix stock for years as part of a planned stock-sale program. While he may have given up millions in paper wealth during the stock's rise, the cash from those sales was protected when Netflix stock fell by nearly 75% this fall. (Many shareholders weren't as lucky, of course.)

In Silicon Valley, the latest wave of tech founders is cashing out earlier and taking more money off the table than previous generations, learning the lessons from the high-beta-rich crashes of 2001. Groupon's largest shareholder, co-founder Eric Lefkofsky, reaped more than $300 million from dividends and stock sales before the company even went public last month.

Last March, Zynga founder Mark Pincus sold a small piece of his stake back to the company for $109 million, according to regulatory filings.

The sale price was $14 a share—higher than the stock's IPO price of $10 on Friday.

"These private sales appear to be increasing, providing the potential for high-beta wealth to take some money off the table," says Mr. Rawlins of Harris MyCFO.