Recently I was having a conversation about where are the missing billionaires, a book which questions why there are so few descendants of historical magnates with fortunes equal or comparable to their founders. I.e. why the fortunes of e.g. Rockefeller descendants do not match that of the original Rockefeller (although to be fair the Rockefeller family is hardly in poverty today). The book makes an argument that the reason is that the heirs to these fortunes mismanaged them and that they could have done a lot better with the combination of modern portfolio theory and ergodicity economics etc.

I have thought about similar questions for a while covered in previous posts such as this post’s namesake and my musings on how human capital ownership will not prevent disempowerment in the post-singularity world. However, I think the question of why most fortunes don’t persist is actually a fairly simple consequence of a bunch of basic high-level facts which we can understand quite well without needing to resort to individualistic explanations. This post just does a quick overview and some very basic financial modelling of these.

Firstly, just to take a step back and look at the outside view. Should we expect fortunes to persist a long time in general? My answer to this is clearly no. The universe is naturally entropic and super concentrated wealth and power is low entropy. Dissipation is the norm. It is much easier to lose a fortune than to maintain or create one. There are many more random shocks in the negative direction than the positive direction. Generally few institutions or families last for long periods of time and compound interest is the least powerful force in the universe.

However, with today’s financial technology, maybe we can avoid this? Using the magic of diversification we can just grow at the average rate of the economy indefinitely. The S&P500 has grown (on average!) at 7% in real terms annually for the last hundred years1, why can’t we just do that?

In theory, you can. Let’s assume you magically made some fortune and it is all sitting in liquid assets which can be maximally diversified, and we are invested in an index fund which gives a steady 7% return year on year. In this best-case scenario, the killers are inheritance and inheritance taxes.

In the US (and UK) the max inheritance bracket is 40%. Let’s assume we have a decent enough fortune that for all intents and purposes it is all in the max bracket. This means that every generation the government takes 40%. This means that to simply ‘stay in place’ we need to compound for just under 8 years to pay back the government. If you have one child then this is fine and that child will get the rest. What happens if you have multiple children? If you have two children this will take 18 years to compound to give each child plus the government your original fortune. Every two children adds another ten or so years of compounding at 7%. Most people who acquire their fortunes acquire them relatively late either in life either because it takes a long time to make it through progressive business success or because their parents die later on in their life. In this case, taking 18 years to break even, even with just two children is a long time to wait. If the generation length is shorter than 18 years or you have more than two children then you are already tipped over the knife’s edge into exponential diminishment with each generation.

Things become worse again if you assume you are spending any of your fortune. If you take the ‘FIRE’ recommended retirement package of 4% drawdown then your real annualized returns drop to 3%. At 3% growth rate simply compounding enough to pay off the government’s inheritance taxes takes 18 years (!). If you want to provide for two children with equal inheritances to your own original fortune it will take 43 years or almost all your working lifespan. Even if you just spend 1% annually on yachts and private jets and old-master paintings etc then it will take 22 years to compound sufficiently to provide for two children with equal fortunes to your starting point.

Even in this idealized scenario, inheritance tax and the division of the fortune among children mean that almost all fortunes are barely able to compound long enough to be maintained even with relatively low TFRs (2 children). Beyond this idealized scenario, the real world also contains many negative ‘shocks’ which can tip a fortune from a regime of steadiness and growth towards exponential diminishment and exponentials are very unkind on the downward slope.

The real stock market, even when highly diversified, does not return 7% annually smoothly forever. It goes through huge bust periods where valuations can drop by 50% or more and can remain below all-time-highs for decades at a time. These times can often be coupled with periods of high inflation2 which are also devastating for large existing fortunes.

In theory, many down-markets can be weathered if you just reduce spending to maintain the same withdrawal fraction. However, in practice achieving sudden 50% or more budget cuts can be challenging, even for the wealthy. Many ‘big ticket’ items such as mansions, yachts, etc have high fixed maintenance costs which cannot easily be reduced in a downturn without selling the underlying asset at precisely the wrong time.

You can also die at an inconvenient time3. If this happens then the inheritance tax kicks in requiring liquidation of assets to fund the 40% levy at almost exactly the wrong time to lock in massive losses unnecessarily and making compounding to ‘get out of the hole’ much harder and take substantially longer for subsequent generations. Similarly, if not everybody in the line of succession is super long lived, this can also trigger massive damage from the inheritance tax. If each inheritee lives on average for 15 years rather than the 18-25 years needed to ‘compound back’ the fortune can easily tip a fortune over onto the road of exponential diminishment. A couple of heirs dying early can completely decimate a fortune. Similarly, a single heir having many children can also cause the snowballing diminishment of the fortune along their branch.

Generally, inheritance taxes are probably the biggest killer of fortunes in the long run. Unlike regular inheritance they require the conversion of assets into liquid money which can be paid to the government. However, most fortunes are by their nature at least partially illiquid. These are either founder stocks in large corporations, which are often private, or consist of large amounts of real-estate which is also fairly illiquid, especially on short notice. This forced conversion-to-liquidity can often entail high transaction costs and slippage which can make the tax much more damaging in practice than the 40% (which is still high!) would appear4.

This fundamental illiquidity of large fortunes also means that diversification is harder to achieve which renders concentrated risks larger and fortunes more vulnerable than they at first appear. Over long time horizons, this is compounded by the fundamental difficulties in indexing the true economy especially new sources of growth, which often dominate returns in practice.

All of these issues provide strong headwinds to maintaining fortunes over long time horizons without requiring special explanations in terms of heir incompetence. Of course the story of any individual fortune has myriad specific details to it, which can certainly include a lot of heir incompetence5, however elucidating the general trends and challenges is intellectually interesting and hopefully somewhat generalizable.

  1. Of course past returns don’t necessarily provide a good guide to future returns. Noticeably the S&P500 is implicitly selected in that it is an index of the world’s largest and most successful economy during the time that the US became and maintained its status as the dominant world power. Many other countries’ indices perform a lot worse over the same period nor is there any guarantee that the S&P500 will be such a great place to invest in the future. Global diversification can in theory counteract this but at the same time, this lowers the real return that one can expect. If we assume returns in the 2-4% range that have been common historically and are at the rough level of developed country economic growth then compounding times become extremely long and fortunes are subject to almost inevitable diminishment from children and inheritance tax. ↩

  2. Note that inflation coupled with capital gains tax functions effectively as a wealth tax. ↩

  3. Crusader Kings2 is an excellent ‘die at an inconvenient time’ simulator. ↩

  4. Inheritance taxes appear to have been the biggest killer of the British aristocracy for whom a large part of their wealth was bound up in their landed estates which are highly illiquid and cannot easily be subdivided. Most stately homes in the national trust ended up there because of inheritance taxes. ↩

  5. We should expect a lot of heir incompetence by default simply because most people are bad wealth managers, since doing it well requires both high IQ as well as a conducive temperament and intellectual interest in understanding arcane and boring details. Outsourcing this to professional wealth managers is often wise but also suffers from the classical principal agent problems. ↩