My Amazon Review of Victor Haghani's and James White's "The Missing Billionaires: A Guide to Better Financial Decisions"

Utility vs. Wealth Maximization

 

Victor Haghani and James White of ElmWealth have written an important, but too academic book, about investing for retirement. Trust me, this not Burton Malkiel’s “A Random Walk Down Wall Street.” In the interest of full disclosure, I worked with Haghani at Salomon Brothers in the late 1980’s and early 1990’s, before he went on to Long Term Capital Management (LTCM). After initial success in 1995, the firm failed spectacularly in 1998. From that Haghani personally learned the importance of sizing of investments. Simply put, he was over-invested in his firm.

 

This is a book more about how much to invest rather than what to invest in. Sizing is critical and the author’s missing billionaires were way over invested in a single asset, and they maintained unsustainable lifestyles. They utilize the concept of the “Merton Share” where the size of an investment is positively related to expected return and negatively related to risk aversion and the square of expected volatility.

 

The goal is to maximize utility, not wealth. Here I will give an example of my own. An investor has an opportunity to invest $9,000 in an investment that has a 1% chance of a return of $1,000,000 and a 99% chance of a total loss. The expected return is a positive $1,000. A pure wealth maximizer might just take the bet, while a utility maximizer would abstain.

 

In order to make their math work Haghani and White assume that individuals operate under “constant relative risk aversion.” For the lay reader this is a nonstarter, and the book is loaded with references to the finance literature. Further, at least in my case, I don’t think it is valid. When I retired, I was determined to have a fortress balance sheet, which saved me more than a little bit of anxiety during the 2008 financial crisis. Once passed, as my wealth increased, I began increasing my risk levels, but retaining a core fortress balance sheet.

 

The authors take the Jane Austin view that a critical measure of wealth is the income derived from it. Hence, they conceptually like annuities, if only they could be structured in a transparent and low fee way. In today’s financial marketplace that is a tall order. My problem with annuities is that they cause confusion between the return on capital with the return of capital.

 

If you follow Haghani’s and White’s advice you would today be cautious about the prospect for long-term returns from today’s stock market. At this writing the earnings yield of the Case-Shiller price-earnings ratio is 3.39% while the five-year TIPS yield is 2.35%. A real equity risk premium of a meagre 1.04% has historically led to very poor future returns.

 

There is much more in this book, but my guess is that the lay reader would find it a difficult go. On the other hand, a reader with financial training will gain much insight.

For the full amazon URL see: Utility vs. Wealth Maximization (amazon.com)