Scott Jones from the University of Arizona has thought about the wealthy. As a former wealth manager, I know that this is nothing extraordinary. A lot of people think about the wealthy, many of them mostly about how to turn the wealth of these people into cash flows for themselves.
But Scott’s thoughts are interesting, because they shed light on who are the ones that invest in stock markets and who are the ones that don’t. We know that wealth is one of the key determinants of stock market participation. Wealthier people are more likely to invest in stocks and that is a good thing because it helps them preserve and grow their wealth. Yet, when you reach the echelons of multi-millionaires and billionaires, you notice that some of them are eager to have a risky portfolio almost entirely invested in stocks, private equity, and the like even if that comes at the risk of potential ruin. Why do people who “enough” still risk everything they own? How can you identify people who are such risk-loving individuals that will never be satisfied with what they have?
Scott’s research suggests that there is a much simpler way than elaborate risk profiling questionnaires with doubtful validity: Just look at how much debt they have. When he looked at the determinants for stock market participation he found that the amount of debt a person has is about twice as important as a driver for stock market participation than the amount of assets that person owns. This is not to say that there is causality between debt and stock market participation. Instead, it seems that having loads of debt and participating in the stock market are driven by the same psychological factors.
A person who “levers up” their personal balance sheet may do so for many reasons, but mostly because he or she is unafraid of the possibility of low returns that drive net wealth into the ground. My wife once met a person in Indonesia who used to be worth something like $100 million before the financial crisis hit. By the time she met him in 2009, he claimed to be broke and have lost everything. But he also said that while “they can take my money, they cannot take my network. I’ll be back at $100 million in a couple of years”. I don’t know if he ever recovered his wealth, but this is the psychology of extreme risk-takers.
If you are confident enough that you will not be ruined or that even if you lose a lot of money, you can always make it back, you are very likely to take on a lot of debt to “enhance” your returns. To me, this would be unthinkable. If I had $100 million, I would make sure that no matter what happened with my stock portfolio, I would always have enough in safe assets to have a good life. In fact, I do this even at the much lower level of wealth I have. I am psychologically programmed to be wary of too much debt. Yes, I have a mortgage on my house, but that is pretty much the only debt I carry. I pay off my credit card debt every month effectively turning my credit card into a debit card. I have no consumer loans and know that when things get bad, the only liability I have to service is my mortgage.
In essence, what Scott’s research indicates is that there are many more people like me and that a simple trick for wealth managers to assess the risk profile of a client is to talk about their debt and how big their debts are relative to their assets. That may give a lot more insights into the “risk profile” of an investor than a risk profile questionnaire.