From the April 2008 issue of Wealth Manager Web • Subscribe!

April 1, 2008

Analyzing Affluence

Get-rich-quick formulas may be a crock, but studying the well-heeled still uncovers common themes for creating wealth, managing it and keeping the heirs out of the middle class.

So asserts the recently published Get Rich, Stay Rich, Pass It On: The Wealth-Accumulation Secrets of America's Richest Families (2007, Portfolio), by Catherine McBreen and George Walper Jr., managing director and president, respectively, of Spectrem Group, a Chicago research consultancy that studies rich folk. "We've found that while there are many ways to get rich, and while there are diverse paths to remaining rich during a single lifetime," they write, "there are only two definitive ways to create the kind of wealth that can be bequeathed to multiple generations." One is owning income-producing real estate; the other is practicing what the authors call "continually innovative entrepreneurship"--otherwise known as building a business.

There's a lot of both going on among the high-net-worth set, McBreen and Walper report. But that's just the tip of the iceberg for insight into how the wealthy think and act. Spectrem's 15 years of analyzing the moneyed class is a treasure trove of perspective on the habits and perceptions of the affluent. Consider a few tidbits drawn from the firm's hefty 2007 study, "The $25 Million Plus Investor:"

o 53 percent of people with a net worth in excess of $25 million identify their risk tolerance as "moderate" and seek "moderate" returns. The comparable figure for the $5 million-plus group is 67 percent.

o 40 percent of the $25 million-plus group identify themselves as "advisor assisted" for their investment efforts; 20 percent identify themselves as "self directed," or as making investment decisions without the assistance of an advisor.

o Most purchases of alternative investments--private equity, venture capital, etc.--by $25 million-plus investors are made without the assistance of an advisor. The exception is hedge funds: 64 percent say they invested in these funds with an advisor's help.

What else can Spectrem tell us about the wealthy? Quite a bit, as a recent conversation with Catherine McBreen reveals.

What led you and your co-author to write Get Rich, Stay Rich, Pass It On?

We started thinking about writing a book shortly after Sept. 11, 2001, when the markets weren't doing so well. We thought people would change the way they'd invest, but we were wrong.

When we talked to people, especially older folks who lived through World War II, [the stock market correction of 2000-2002] was sort of a blip for them. They were used to markets going up and down. The younger generations were more frazzled by it, but nobody was making huge changes [in their investing strategies]. During the interviews, we started coming across consistent themes. One was that wealthy families talked a lot about their real estate holdings and how they'd created their wealth.

What did you learn?

In a lot of cases--not all, but in many cases--people had created their wealth on their own, through ownership in a business. In other words, they didn't necessarily inherit their wealth. We thought that was interesting and after 15 or 20 interviews, it looked like a theme. We wondered how the theme compared with our quantitative research, which comes from Spectrem's 15 years of analyzing wealthy families. As it turned out, our data supported the themes we uncovered in the interviews, and so we continued talking to people about how they created their wealth.

As it turned out, almost all of the wealthy people we interviewed held real estate investments that I would call income-producing properties. Very few bought things and flipped them. Instead, they favored long-term investing in commercial properties of one type or another--properties that they were renting out. The point is that the income from the real estate is a critical part of how they built and maintain their wealth. In fact, many of the people we interviewed were planning on passing on the real estate investments to the next generation.

Why is income-producing property favored by the rich?

They feel like they're giving their children or grandchildren a solid financial base. We learned that a lot of people think that real estate retains a lot of its value. That's hard to say in this market right now, because real estate values are slipping. But over the long term, real estate kept its value.

How do equity and fixed-income securities compare?

For households in the $5 million to $25 million wealth range, stocks and bonds represent about 38 percent to 45 percent of the net worth. As you get wealthier, the proportion of stocks and bonds becomes even greater.

Why is that?

I think it's because they have more assets to invest. They say their savings rate is 20 percent to 25 percent, which is a really high number if you think about their income.

What other interesting trends did you uncover about the wealthy as it relates to finance?

Our data show that household wealth among certain types of wealthy professionals--doctors and lawyers, for example--generally caps off at about $10 million to $15 million. A doctor creates wealth, has a great salary and probably owns stocks and bonds. But when that doctor passes away, the son or daughter must, in essence, create their own stream of wealth, whereas small business owners can more effectively pass on a business and preserve wealth for heirs. In almost all cases, our data show that business owners were much wealthier and more successful in passing on wealth. Unless a doctor or lawyer bought income-producing properties, at the end of his practice he passes on whatever stocks or bonds he owns.

So among the wealthy, business owners tend to be richer than doctors and lawyers. Is that because you can't pass on a medical or law degree, but you can bequeath the family business?

That's a lot of it. It's also because business owners tend to invest in a lot in things related to their business, and so they create greater wealth in their business. They may own the buildings that house the business, for example. Sure, a doctor may own the building where his practice is located, but business owners tend to invest in a wider network of things related to their business. Also, the value of the business is generally greater [than a medical or law practice] if it's producing something.

It's hard to sell a dental practice.

Exactly.

But if you own a widget factory...

You can sell the widget maker.

Going back to real estate, how do the wealthy use REITs, if at all? Does REIT ownership vary in relation to household wealth?

No, it doesn't vary significantly. Something like 3 percent to 4 percent own REITs, but it doesn't change proportionally [with household wealth] as an asset class. The wealthy invest more in actual properties, and REITs are treated more like a mutual fund by these households.

What about alternative investments?

Almost all wealthy households own some type of alternative investment, whether it's a real estate limited partnership or private equity. And the wealthier they are, the more likely they'll own alternative investments.

Hedge funds, too?

I was surprised at how many households owned hedge funds. In fact, some of the households are actually hedge fund managers! But not until the $20 million to $25 million household-worth range do people start to invest in hedge funds.

Does ownership of hedge funds rise with household wealth?A little bit. It will go up to 5 percent to 7 percent for the $25 million-plus households, which is higher compared with lower-wealth households.

How do financial advisors fare in your studies of the rich?

Roughly 75 percent of wealthy households use a financial advisor of some kind, although the remainder define themselves as self-directed investors who make their own decisions. But even those who say they're self directed sometimes reach out and listen to advisors before they make decisions.

Meanwhile, we find that people tend to be more collaborative with their advisors these days compared to five to 10 years ago, when people were more likely to hand things off to a financial advisor. Today, even the very wealthy are regularly involved with what's going on with their finances.

We're also finding that people still use a full-service broker, especially among the older generation. But that full-service broker does a lot more these days; they're not just placing trades.

Is the $25-million-plus crowd more likely to use "full-service brokers"?

Yes, but these full-service brokers probably call themselves wealth managers. But the term probably doesn't mean a lot to wealthy households, especially those who are of a certain age. I would argue that people who are 65 years or older probably don't know what a wealth manager is even though they may be using one.

When it comes to financial advisors courting the wealthy, what's the biggest potential for misunderstanding?

I think it's that providers [of financial advice and services] believe that wealthy people are more reliant on them than the individuals believe they are. The wealthy believe they're managing on their own, whereas providers tend to believe that their clients think really highly of them. In fact, in most cases clients think negatively of [advisors]. That's a little disturbing. They may not be negative about their attorney or accountant, but sometimes they didn't think that highly of their investment providers.

There's probably stronger loyalty to an attorney or accountant than to an investment advisor. Then again, it may be that wealthy clients think they're really smart, and so if they're not getting great returns it's easy to say that the advisor screwed up, whereas you don't really second-guess your attorney.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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