By Michael Tierney, April 16, 2021
“…I required a great deal of boldness and a great deal of caution to make a great fortune; and when you have got it, it requires ten times as much wit to keep it.”
Nathan Mayer Rothschild, 1834
In the early 1800s, London’s Nathan Rothschild was the wealthiest and most powerful businessman in Europe. He was the head of a group of Rothschild brothers with offices in Frankfurt, Paris, and beyond whose clients were the royalty and governments of those countries.
Entropy is a scientific term for a physical law that measures the constant degradation of matter and energy in the universe. In wealth management, entropy can be defined as the constant force in the world separating one from one’s wealth. Of Greek origin, the term’s first known use was in 1867 – thirty years beyond Nathan Rothschild’s death. While it is fair to say that he was unfamiliar with the term, he was keenly aware that the forces of destruction on wealth, working against its expansion and perpetuation, are exponentially greater than the energy required to create it.
It is these forces that successful wealth managers with ultra-high net worth clients must combat, and their success can be measured by the degree to which they hold the forces of entropy at bay.
Progenerating is about the most significant natural dilutive force on concentrated wealth across generations, assuming equitable distribution to heirs, which students of history know has not always been the case. And while there are surely matriarchs and patriarchs throughout history who have privately advised their heirs of its costs, there is not much of a commercial calling for advisors to arm families against it in our modern society. Beyond that, however, the remaining list of entropic forces, while creating many obstacles, can be conquered. With diligence, persistence and just about constant attention, families of significant wealth can limit these destructive forces on almost all of entropy’s varied fronts.
The most obvious of the remaining entropic forces are taxes, in all its forms. Estate tax, however, could potentially be a bomb ticking away in a family’s vault.
Unaddressed estate tax is a fully armed destructive force. Not only can it deeply impair an unprepared family’s asset base in one fell swoop, but adequately preparing for it may be one of the easiest things in the world to put off today what you can do tomorrow. Truly comprehensive estate planning for wealthy families is planned and executed over a period of years in most cases, it is all about the structure of trusts and strategies not found through an elementary Google search. However, planning for it is often a deeply emotional experience for the family decision-makers. Hard work, over a period of time, and the difficult decisions required for this process may generate raw emotions that many spend a lifetime suppressing – you can see why entropy wins so often.
The list of entropic forces acting against one’s wealth goes on from there. In addition to spending and inflation, there are investment-related entropies to be minimized: fees (hidden and stated), investment losses, volatility drag, and of course, the return one does not achieve annually for the risk taken in an inefficiently or insufficiently invested portfolio. Inefficient portfolio investing is another potential silent disaster as is a common occurrence of underinvestment in growth assets. A fear of paying capital gains taxes caused by rebalancing assets or an attachment to certain assets for sentimental or historical reasons can also lead to investment-related entropy. Even modest annual underperformance, compounded over years is a fortune, and is often enough to support an entire family generation of the future.
Other obstacles are also theft, divorce, illness (physical and mental), philanthropy if done in a non-strategic manner and ultimately death. Perhaps Nathan Rothschild underestimated entropy as “it requires ten times as much wit to keep it,” or maybe these destructive capital forces have gotten stronger since Nathan’s day.
As the wealth management industry has evolved, it has resulted in a collection of specialists much like the healthcare industry.
Investment and non-investment service providers to the ultra-high net worth community have circled around one entropic force or another: accounting, law, and investing are the most common silos of specialization. Done properly, families of wealth today must spend considerable time and money to buttress their family fortune against the wide spectrum of destructive entropic forces. A wealth manager for families of significant wealth today needs to pay close attention to these forces and to play a key role in sourcing, vetting, selecting and ultimately quarter-backing the team of specialists needed to build this fortress.
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