“The way is long if one follows precepts, but short… if one follows patterns.” – Lucius Annaeus Seneca

 

The Pareto Principle, Part II:

A Universal Law That Even Applies to Business 

The Pareto Principle would be a significant contribution to learning if it applied only to economics. But as I said in Part I of this series, it applies to just about everything. Whenever and wherever you measure resources or the relationship between cause and effect, you’ll find this lopsided distribution.

A few examples:

* 80% of taxes are collected from 20% of taxpayers.

* 80% of government spending goes to 20% of its expenditures.

* 80% of new technology is patented by 20% of technology companies.

* 80% of the drugs approved each year are made by 20% of the research labs.

* 20% of criminals commit 80% of all crimes.

* 20% of drivers cause 80% of all traffic accidents.

* 20% of factories produce 80% of the pollution.

* Through the 2015-2016 NBA season, 20% of franchises won 75.3% of the championships.

I could go on, but you get the point. Economics. Science. Human behavior. Sports. In playing with his pea plants, Vilfredo Pareto seems to have discovered some sort of universal pattern.

We’ll look into the philosophical implications of this on Friday in Part III. Today, let’s take a look at how the Pareto Principle applies to something very practical. Let’s talk about business.

 

Understanding business through the 80/20 lens 

I don’t remember exactly when I first read about the Pareto Principle, but I’m certain I did not grok it early in my career. It wasn’t until I was running a multimillion-dollar company in which I had secured a profit share… and there’s a good reason for that. There’s something about aligning one’s interests with those of the business that makes such insights invaluable. It is immensely helpful in analyzing problems, understanding challenges, and making important decisions.

Since then, I’ve written about the 80/20 rule many times. And now that I think about it, I can say that the Pareto perspective was responsible for all of my bestselling business books, including Automatic Wealth and Ready, Fire, Aim.

There are so many examples of how the Pareto Principle applies to business:

* 20% of a company’s salesmen produce about 80% of its sales.

* 20% of a company’s customers/clients account for 80% of the purchases made.

* 80% of all customer complaints come from 20% of the customer base.

* 80% of customer complaints are related to 20% of the company’s products.

I could list hundreds.

But there are three categories that stand out:

 

  1. The 80/20 rule in product development 

If you look at almost any business, you will find that about 80% of its revenues come from only 20% of the products sold.

This seems obvious to me now. It’s almost a bromide. But it was a revelation when I first figured it out.

At the time, we had about 20 product lines and were doing about $20 million in revenues, with average revenues of $1 million per product. I was well aware that some products performed much better than others. But until I looked at our sales from the Pareto perspective, I didn’t realize how lopsided the distribution was.

Sixteen of our products generated sales of $5 million. They averaged just $312,500 each. The rest of our sales – $15 million worth – came from just 4 products. An average of just under $4 million each.

The imbalance was much more extreme than I would have guessed. But it allowed me to understand, instantly, that my habit of giving equal attention to all of our products was a big mistake.

The cost of producing and marketing each product was about the same, but the revenues were so terribly uneven. It was easy to see that we were basically losing money on 80% of our products and making huge profits on just 20% of them.

If profits were the lifeblood of a business (and they are), why was I not giving 80% of my time and attention to the 20% that would yield 80% of our profits?

We had ben dividing our marketing resources equally among the products we were selling. After understanding the Pareto Principle, we directed 80% of those resources to the top three or four. That resulted in a much faster-growing customer base, and, subsequently, higher revenues and profits.

 

  1. The 80/20 rule in customer spending 

After learning that lesson, I began to apply it to every other aspect of our business. One challenge had been the issue of customer lifetime value.

In our industry (information publishing), we measured our long-term success by renewals. The average first-year renewal rate was about 20%. It was generally accepted that if you could raise it by increments – to about 50% in the second year and 60% thereafter – you could grow the business.

Then one day I met a man named Jay Abraham who had a crazy idea he was peddling about what he called “the back end.” The idea was that instead of trying to boost our renewal rate by increments, we could do much better by immediately selling existing customers more expensive versions of what they had already bought. If, for example, they had spent $39 for a newsletter on executive productivity, we could sell them a special report “on the backend” written by an expert on the same topic for, say, $79.

I got it instantly, because I was thinking in terms of 80/20. I was pretty sure that 80% of our existing subscribers would never buy a more expensive back-end product, but that 20% of them would. And the first test we did – selling an information product for hundreds of dollars – more than verified that. It blew us away! (Today, the same sorts of back-end information products often sell for thousands.)

 

  1. The 80/20 rule and the people you depend on to make your business grow 

Those two applications of the Pareto Principle made me a better at developing products and marketing them. But I’m most excited about a realization that came late in my career.

I was thinking about the writers, editors, publishers, copywriters, and marketers I had worked with, and it occurred to me that Pareto’s Principle applied to them as well: A relatively small percentage – maybe 20% – had been responsible for the great majority of the business success I had witnessed.

I should qualify that. Building a business is a collaborative effort. Dozens or hundreds of people are involved in getting the work done.

But it would be naïve to pretend that everyone is equally responsible for its success. There is always a small number that stand out clearly. They work harder. They think harder. They never run away from a problem. They never hide a mistake. They treat your business as if they owned it. In the skyscape of any company’s employees, they shine where the best of the others only glow.

Although money matters to them, these superstars are not motivated by it. Nor are they motivated by the desire for approval. They are unique. They are rare. And they are worth their weight in gold.

Based on my observations, if you are very lucky, 20% of your employees will be superstars.

Something to seriously consider.

I’ve heard it said that the Pareto Principle is the best-kept secret in business. That’s difficult to believe if you are familiar with business literature. There are literally thousands of articles, essays, and manuals written about it every year.

So, no, it’s not the best-kept secret in business. But it is routinely ignored. I’m not sure why that is, but I do know this: If you pay attention to the Pareto Principle in your business, you will be glad you did.

 

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Pareto Principle, Part I: The Secret of the 1%

 

“Give me the fruitful error anytime, full of seeds, bursting with its own corrections.” – Vilfredo Pareto

It may be the most important idea in economics – but it also applies to science, to sports, and to human behavior. It explains not only why things are the way they are, but also why, no matter how you try, it’s almost impossible to change them.

Welcome to a series of essays on the Pareto Principle!

As you can surmise from that introduction, I have a lot to say on this subject. And lest you think it’s going to be episode after episode of longueur, I promise to focus on ideas you haven’t heard before.

Today, I’m going to tell you how the Pareto Principle relates to economics generally and wealth inequality specifically. I’m going to show you why every modern economy in the world is subject to it. And I’m going to present a new principle derived from it – the Masterson Mandate – that explains the phenomenon of “the 1%.”

In Part II of this series, I’m going to talk about how it applies not just to economics but to virtually every aspect of life. I’ll explain, in particular, how helpful it was for me to understand its business implications.

In Part III ,I’m going to try to connect the Pareto Principle to the second law of thermodynamics. I’m going to argue that it is a layman’s explanation of how entropy works – and how every form of human achievement is a sort of futile attempt to defy the universal and inevitable drift towards chaos.

How’s that sound?

 

A bit of history… 

Just before the turn of the last century, an Italian economist named Vilfredo Pareto published an essay in which he observed that 80% of the land in Italy (the primary form of wealth back then) was owned by 20% of the population. This ratio, he asserted, was not unique to Italy. It was roughly the same for all the European countries.

And it was true not only of wealth but of income. In researching English tax records, for example, he found that there was a similar (though not quite as severe) imbalance: About 30% of the population made about 70% of the national income.

Looking at other economic factors, Pareto found the range of ratios: 70/30, 80/20, and 90/10, with the average being about 80/20. He pointed this out in his first essay, published in a French economic review, and in several later publications.

It is hard to imagine that he was the first to make this observation, but he gained worldwide fame for it, and his name has been associated with the phenomenon ever since.

When you consider the diversity of cultural and economic conditions in Europe during Pareto’s time, you wouldn’t expect wealth and income to be distributed so similarly. It was surprising when he wrote about it, and it’s still true today. According to a 1992 United Nations Development Program report, 20% of the world’s population controls 82.7% of the world’s wealth.

 

What’s happening here?

How is it possible that for more than 100 years economists have seen this grossly uneven distribution of wealth in every industrialized economy?

There have been several hypotheses, but the one that has the most support is something that academics call the “Accumulative Advantage.”

It goes like this: In any random population, some percentage of that population has an economic advantage. It might be inherited wealth. It might be family connections. It can be luck – being in the right place at the right time. Most commonly, though, it is education.

Of those that have such an advantage, a percentage of them put it to work. Even if the advantage is relatively small – say, having a master’s degree rather than a bachelor’s degree – it is enough to move those that have it forward.

By continuously applying that advantage over time, the advancements become larger. Eventually, they become exponentially larger. After a generation, the difference can be enormous.

 

A new look at a very old problem 

It’s hard to find an economic topic that has been hotter in the past 10 years than “wealth and income inequality.” Everyone seems to agree that it is a grave problem that in some places, such as the US, is getting worse.

In these discussions of economic inequality, however, the Pareto Principle is rarely invoked. Instead, the discussion focuses on the concern that so much of the wealth is owned or controlled by a mere 1% of the population.

It’s a legitimate concern. The top 1% own a vast amount of wealth compared to the 99%, and the gap between them is getting larger.

But when we look at wealth inequality through the perspective of the 1% versus the 99%, we are making a serious mistake. The fact is, the widening wealth gap is not just between the 1% and the 99%. It’s between the 20% and the 80%. In other words, the wealth gap is a Pareto problem – the same problem we’ve had for at least 130+ years, and quite possibly forever.

 

How to explain? 

Let’s assume for the moment that the 80/20 ratio is a universal economic law – that, no matter what you do, economies will reconstitute themselves to put 80% of the wealth in the hands of 20% of the population.

If that is the natural order of things, what is the percentage of wealth that the 1% would “naturally” own?

This seems, at first, to be an easy bit of arithmetic. One percent is 5% of 20%. So if the 20% own 80% of the wealth in any given economy, the 1% should own 5% of that 80% – or 4%.

Right?

Maybe. But what if the Pareto Principle worked within the 20%? What if the top 20% of the 20% owned 80% of what the 20% own?

In that case, we would look first at the 4%, not the 1%, because 4% is 20% of 20%. So the calculation would be that the top 4% of the general population should own 80% of the 80% or 64% of the national wealth.

Do you follow?

I’ll do it again…

Let’s call this new theory – that the Pareto Principle is regressive – the “Masterson Mandate.” The Masterson Mandate suggests that 20% of the 20% (or 4%) should own 64% of the wealth of the general economy.

Twenty percent of 20% is 4%. If 80% of the world’s wealth is owned by 20% of the population, then 20% of that 20% – or 4% – should own 80% of the 80%, which is 64%.

Okay. One more time: 20% of 4% is 0.8%, and 20% of 64% is about 12.8%.

 

Now to the 1%… 

What is 1% compared to 4%? It’s 25%. That’s not 20% – but since the Pareto Principle is not an exact ratio, we are going to accept the 25% as consistent.

We said that the Masterson Mandate would suggest that 4% of the population would own 64% of the wealth of the larger economy. It would also suggest that 25% of the 4% (or 1%) would own about (a bit more than) 80% of that 64%. Eighty percent of 64% is about 50%.

Holy cow!

The Masterson Mandate suggests that the natural state of things is that the top 1% of any economy should own 50% of the economy’s wealth.

In the US, the top 1% owns 40%. Does that mean they haven’t yet acquired their “natural” share? Does it mean that the wealth gap should continue to increase?

Alas, I cannot answer these questions right now. I only this moment came up with the Masterson Mandate. It will require further study.

More coming…

 

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“I’m not sure this business is for me,” he said.

“Why is that?” I asked.

I’d been mentoring TJ, the son of one of my partners, for about a year. I was helping him develop a small business that I’d started the year before. His initial motivation had flagged a bit in recent weeks. I wanted to know what was bothering him.

“I just don’t see any way it can make me a billionaire.”

“A billionaire? Why do you want to become a billionaire?”

He proffered a few unconvincing answers. Finally, he told me the truth: If he was going to go into the business, he said, he felt he needed to surpass his father’s success. At the time, his dad was worth hundreds of millions of dollars.

“Man,” I said. “That’s a heavy burden.”

 

Wealthy Is Not a Number 

Self-improvement books and magazines are replete with the same advice: When it comes to setting any goal – especially a “get rich” goal – make it big and make it specific.

When I first began thinking about building wealth, that idea didn’t occur to me. Today, looking back, I’m glad it didn’t. As I see it now, there is only one minor benefit to that kind of goal setting and many major downsides.

First: Really big goals, like “becoming a billionaire,” are statistically as realistic as deciding to become an NBA MVP. If you are amazingly talented, extraordinarily hardworking, and incredibly diligent, you might be able to bring your chances of success up to one in ten thousand.

Second: Since your chances are so infinitesimally small, the likely result is that you will be seen by virtually everyone you share it with – whether it be your family, your friends, your potential partners, or your employees – as a nutter.

Third: You are defining a career of failure. From the moment you set the goal to the moment you give up on it (or die), you will be living as a wannabe. That is not good for the ego.

But it’s not just the bigness of a billion dollars that was wrong with TJ’s goal. Again, I know that most self-improvement pundits say the opposite. But specific numerical goals will give you only the briefest satisfaction if you achieve them, followed by another long, frustrating period of chasing some new, more ambitious number.

Numerical objectives can be very helpful in trying to achieve (or motivating others to achieve) specific short-term objectives. But for the big things – like life satisfaction – they are useless and even counterproductive.

The moment you achieve them, you experience about 24 hours of exhilaration. After that, the good feeling is replaced by an anxiety-ridden ambition to reach a new goal.

When I started to make “decent” money, I set my first specific financial goal: to pay off my mortgage, which was about $150,000. I did that fairly quickly – within 18 months. As soon as it was taken care of, I set another goal: to put aside a million bucks in savings. I achieved that goal the following year. But by that time, I was thinking about selling the house I finally owned free and clear and buying another one that was five times more expensive and would require me to get another mortgage.

Something similar happened every time I set a specific financial goal. Two days of fun – the first day and the day I hit my goal. And in between, months or years of angst and obsession.

Then, sometime before my 50th birthday, I had a conversation with a friend that helped me jump off this vertiginous mental merry-go-round. It led me to a simple idea that changed my life. Maybe it will have the same effect on you.

The idea is this: Don’t strive to attain a certain amount of wealth. Strive, instead, for the feeling of being wealthy. 

It’s a bit trickier than it sounds.

When I say the “feeling” of being wealthy,” I don’t mean the way you might feel when you picture yourself owning the things that are usually associated with being rich – the houses, the cars, the yachts, etc. I mean the way certain experiences make you feel.

For me, the feeling that I had always associated with being rich was having a sense of ease and independence and possibility. And the experiences that gave me that feeling were such simple things as having a drink in the lobby of a beautiful hotel… reading a book on a comfortable chair in a library… or smoking a cigar on a walk on the beach.

Having identified the feelings that I associated with being rich, it was easier to give up the desire to keep hitting higher financial targets.

I realized that I didn’t have to pay off my mortgage to be happy, I just had to be on the way. I didn’t have to have a million or a hundred million in the bank. As long as I had enough to pay the bills, I could have all the relatively inexpensive “rich” moments I wanted.

I wrote a book about this, called (unimaginatively) Living Rich. The premise was that if you pursue the feelings of being rich rather than some specific financial goal, you will find that you will be able to feel rich while you become rich.

As I said, this was an idea that changed my life. It did not change me immediately and 100%, but it gave me a way to think about my life that put everything into focus. Decisions were easier to make. Mistakes were easier to admit to. Urges and impulses were easier to resist – especially those tied to the ambition of making more money.

If you have specific financial goals that are stressing you out, this is something you might want to think about.

Start with the best moments of your life – the times when you felt like “This is what it’s all about.” If, like me, they were about simple experiences, you will probably also associate those experiences with the sorts of feelings I have described. And if that’s so, welcome to the don’t-worry-be-happy club.

 

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“The most reliable way to forecast the future is to try to understand the present.” – John Naisbitt

 

Investment Real Estate Outlook for the Rest of 2020 and Beyond 

On Sunday, I briefly answered a question sent in by P.J., who asked: “What do you think about real estate, given what seems like an inevitable recession and possibly worse?”

I explained that I am concerned – very concerned – for two reasons:

 

  1. The economy – the real economy, not Wall Street – is in serious trouble. We have huge unemployment and record levels of small businesses shutting down for good. That’s bad for a good swath of real estate: all the buildings that cater to smaller businesses.

 

  1. The extended shutdown has given tens of millions of American workers and thousands of companies the opportunity to experience business with an office-less office. We’ve learned that so much of what was being done in the office can be done just as well remotely. We’ve also learned how convenient it is to have everything we consume – food, clothing, toys, entertainment, etc. – delivered to our homes. This has already had a huge impact on the way we work and live. I’m expecting to see more employees working from home and less office space leased per dollar earned.

 

These two realities are definitely going to affect the real estate market. So today, I’m going to give you my off-the-cuff thoughts on what those effects will be.

 

The Real Estate I’m Worried About 

 High-End Shopping Centers 

Three of my book club friends have made their fortunes developing large-scale, luxury shopping centers and strip malls. They are partly retired now, so I suspect their current positions in these properties are limited. But I’m going to ask for their thoughts at our next meeting. If I owned a lot of that kind of real estate now, I’d be worried.

 

Class-A Office Buildings 

 During an extended recession, many businesses are forced to cut down on all non-vital expenses. Given this, and considering what I said about so many people working remotely, I would not like to own a lot of such buildings right now. I am not predicting a collapse of this kind of property. But if the economy stays sluggish and GDP stays low, we will likely see steeply dropping ROIs as tenants do not renew their leases.

 

Luxury Single-Family Homes

I have another friend that’s been doing quite well building and selling million-dollar homes for the last 10 years. This has been a side business for him, but it’s netted him a profit of about $500,000 per home. At breakfast recently, I asked him how he was doing. “I was between houses when this thing started,” he told me. “I’m not going to do anything until the economy starts moving again.”

 

High-End Residential Developments

From about 1990 to 2004, I was a regular investor in a friend’s residential real estate developments. He built and sold 100- to 400-unit developments at $400,00 to $600,000 a door. And even though those units are worth more than a million each now, I wouldn’t invest a dollar in a new project like that today.

 

Other Luxury Properties

I just spoke to a guy that wants to build a $32 million, super-duper sports complex here in Delray Beach. He sent me the brochure. It looks amazing. He’s going to ask me if I want to invest. I’m going to say no.

 

Middle-Level Commercial Properties

If Class-A commercial isn’t appealing, Class-B commercial is even less attractive today. My experience with that kind of income property is that it is much less resilient than residential properties during a recession. You can keep your houses and apartments rented during economic slumps by simply lowering the rent. You can’t do that with middle-level commercial properties. They can sit unoccupied for years.

The tenant in a commercial building that I own in Delray Beach has been asking me to sell him the building for more than five years. I was getting a great return on this investment, so I wasn’t interested. Yesterday, I signed it away.

 

Hotels (and Motels)

What have I forgotten? Oh, yes, hotels! That’s an easy one. If I were invested in hotels, I’d definitely be worried today… Hey, wait! I just remembered. I am invested in hotels – at least a half-dozen of them through my brother. So I am worried! But for him, not me. Since I’m a limited partner in these properties, my potential losses are limited to my original investments. But as the general partner, he’s on the hook. Big time. Right now, he’s jumping through hoops to keep the doors open. He’s doing a great job of that, but if occupancy drops by, say, 50% for the next several years, things could be bad.

 

REITs? 

 I don’t own REITs (I don’t think), because I own so much property directly. But if I had a significant position in REITs, I would want to check the sort of property they were holding and measure it against the concerns I’ve mentioned above.

 

The Real Estate I’m Not Worried About 

 

Working-Class Apartment Buildings

I’m not worried about the apartments I own in working-class and middle-class neighborhoods. The rent rolls would probably go down in an extended recession, but not hugely, because new construction would come to a halt. Since my total debt load on those properties is less than 5%, I’m confident I’ll be able to maintain them even at a rent reduction of 50% or more. Plus, the asset value should return when the economy returns.

 

Company-Occupied Office Buildings

I’m not at all worried about my investments in the dozen or two office buildings whose tenants are companies I own or control. These have always been my favorite properties because my partners and I can control the rents and mandate payments. Plus, most of these companies are in the digital-information business, which has not been badly affected by the Corona Crisis and will probably do okay going forward, even if we enter into a period of economic doldrums like we did after 2008.

That said, I just put a $14 million project on hold in Delray Beach because my partners and I want to see what happens with the economy and our local businesses before moving to the next step (construction).

 

Land Banking

And finally, I’m not worried about the properties I’ve bought over the years for “land banking” purposes. These are well-situated lots and acreages that provide no income but cost very little to maintain. Since they were always long-term plays – and by that I mean 20 to 50 years – I’m not sweating about them now.

 

What All This Amounts To

I believe that many parts of the real estate market are going to be hurting over the next few years – principally, the high end.

I believe there is a good possibility that the shift towards working at home will continue, and that will temporarily drive down income from office buildings and reduce the size of that market over the longer term.

I have the same long-term concerns for high-end and even middle-level retail real estate.

But even though my partners and I have had some rent deferrals and vacancies in our residential properties, I’m not worried about those investments because of the safety margins we operate with.

When it comes to investment real estate, I’ve always been very conservative. I invest primarily for income (not growth) in income-producing properties for which there will always be a demand. And I use leverage (mortgages) on a temporary and limited basis.

My formula is not optimal for increasing wealth in an up market. But it is good for reducing my exposure to a long down market.

 

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 “Gratitude is merely the secret hope of further favors.” – François de la Rochefoucauld

 

The Unpleasant Truth About Asking for Favors

I recently intercepted a memo from a partner of mine. It appeared to be a nothing-much memo regarding a not-all-that-important request for a favor from a business associate – but I intervened because I thought it could ultimately be damaging.

Mutual back scratching, as I’ve often said, is a big part of good business. All the successful business relationships I know of – at least the ones that last – involve a lot of back and forth. I do such and such for John, and sometime in the future he will reciprocate. If he doesn’t, I cross him off my list. Unless I’ve done him a foolishly big favor in the first place, losing my good will costs him more than he gained from my initial service.

It’s All About Give and Take

Smart businesspeople (those who think long-term) don’t demand an immediate quid pro quo. They are happy to let the credits add up by helping out where they can. But unless they are saint-like, they do keep a running tab in their heads. And when the time comes to ask for service in return, they expect it.

That’s the way it should be. And when businesspeople act that way, they prosper. Just as important, the products and services they offer tend to improve because of the exchange of information and technology. And this benefits their customers.

But not every businessperson is that smart. Many fall short when it comes to cooperation in general and favors in particular. If you randomly selected a dozen business owners and lined them up against a wall, you’d find a considerable range of enlightenment as far as cooperation is concerned.

And that’s why you have to be careful when you ask for favors. Because the person from whom you are requesting the service may not think of it the same way as you do. Such was the case with the favor my partner was about to ask in the memo I intercepted.

The favor was for the other company to do some printing and mailing for her – things she would have been happy to do for them. What I think she failed to understand was the reaction her request was likely to cause. I happen to know the people who run that business. I’ve worked with them for years. And though they are good people, they have a tendency (in my view) to overvalue their work and undervalue that of others.

There was another factor, too, that she failed to take into consideration. My partner’s view of the favor she was asking was somewhat distorted. Because she runs a smaller business, it would have been fairly easy for her to personally manage the printing of a job for them. But since their operation is larger, a similar task would have involved several people… and required checks and double-checks… with no organized way to account for the work done.

Between my partner’s honest misunderstanding of what she was asking and the tendency of those she asked to overvalue their contribution, trouble was brewing. They would have done what she asked, but my partner would have incurred a big “You owe me.” A debt she wouldn’t recognize. Which would have made matters worse.

My advice to her? “Take care of the printing yourself, even if it costs a little more. If you are going to ask for a favor from these folks, make it a good one – because in their eyes, any favor will be a big one.”

It’s too bad it sometimes has to be that way, but that’s life. You can’t expect everyone to see things the way you do, especially when it comes to valuing personal efforts.

My own policy is to help others as much as possible. Mostly what people want from me is knowledge or access. How to do something or an introduction to someone. When I’m asked, I generally give. But I almost never ask for favors in return. And I don’t keep a close count. I simply notice when someone is always asking, when the relationship has become a one-way street.

When that happens, I don’t drop them. I sometimes – rarely – refuse their request and explain why: that I think they are abusing our relationship. But most of the time, I take a softer approach and gradually become less and less responsive till the relationship dies out. I do that, I think, because I realize that people that are myopic in that way will never be able to admit the truth to themselves. They will, instead, consider my telling them the truth to be an insult they will not forgive.

There’s no advantage to causing hard feelings in those that you don’t plan to have anything else to do with.

The way I look at it, finding out the character of a person is worth something. And I’ll pay that price in advance. But I won’t overpay.

A greedy, self-centered person believes he can live a better life by taking advantage of others. What he fails to realize is that the people he dupes have memories. And influence. Eventually, his world gets smaller. He has very few friends. Fewer business colleagues he can count on. Little credit. And the high-pressure climate of the bad feelings he’s stirred up. He may have a considerable store of material things, but he doesn’t have the faintest idea how to enjoy them.

So do favors. Keep a rough count. And always keep in mind that the size of the favor is a matter of perception.

 

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Passion is a popular emotion these days. We are encouraged to be passionate about our careers, our hobbies, and even our ideas. Like most popular ideas, this one is mostly wrong. On the risk/reward scale, it ranges between dumb and dangerous. But there are some noteworthy exceptions.

One of them is art. Let’s talk about that.

 

Why It’s Okay to Fall in Love With Your Investible Art* 

“They say you cannot argue taste. Of course you can. It is one of the most rewarding conversations two people can have.”– Michael Masterson

When investing in real estate, it’s generally a bad idea to become emotionally attached to what you are buying. When considering the purchase of a rental property, for example, you should determine what to pay for it by studying market rates for “comparable” properties in the area, not by some subjective feeling about how “cute” the place is.

The same is true for stocks or precious metals or digital currency. Buying and selling decisions should be based on market metrics. Innumerable studies have shown that when investors fall in love with individual assets or asset classes, they tend to do poorly in terms of long-term gains.

It also makes sense for art investors – especially new and amateur investors. If you want to give yourself the best chance of getting optimum, long-term returns, you should make your buying decisions based on verifiable data, not on how much you love the piece.

That goes against the most common advice art brokers and dealers give their clients: Buy what you love.

They do this for two reasons:

When a buyer loves a work of art, he is much less likely to be critical of its value. It goes like this:

“I love that!” he exclaims.

“You have great taste,” the broker assures him.

“How much is it?”

“It costs $X. But it’s a great piece and a good value.”

So that’s reason number one. When the buyer loves a piece of art, it’s easier to sell it to him.

The second reason is that when an investor loves a piece of art, he’ll be more likely to keep it. His attraction to it was validated by the broker. (“You have good taste.”) And his decision to buy it creates what psychologists call confirmation bias. (He wants to believe he made the right decision.) So if, in the future, the investor discovers that the piece is worth less than he paid for it, he’ll be more likely to believe that the lower valuation is wrong than to question the integrity of the broker that sold it to him.

Does this mean that the art investor should never fall in love with the art he buys?

My answer is yes and no. Or, rather, no and yes.

You should not allow your love for a particular piece to influence the price you are willing to pay for it. You should, as I said, make that decision based purely on verifiable market data. But after you have bought a piece at the right price, you can fall in love with it. Because forming an emotional attachment to a well-priced piece of investment-grade art will work in your favor.

Let me explain.

When I buy investment-grade art, I am looking primarily for value. I’m looking to buy a piece that is priced at or below its current value – as determined by current auction prices for similar works by the same artist. It doesn’t matter whether I like it or not. My decision is based on the numbers, not on my feelings.

After the buy is made, I put my investment mind aside and allow myself to fall in love with the piece. And interestingly, most of the time, I find that I do.

Falling in love with well-bought, investment-grade art makes it more difficult to sell it when an offer is made. This creates a bias towards holding the art for a long time. And that is definitely the way to optimize your ROI as an art investor.

When I bought my first piece of investment-grade art, an oil painting titled Invierno (Winter) by José Clemente Orozco, I had a reasonable expectation that it would increase in value. I knew that Orozco was one of the three most important muralists of the 20th century, that his production of small oils was limited, and that the market for Mexican art was heating up.

But I also liked the image. The three figures, standing outside in the cold as if they were waiting for something, intrigued me. I liked the way the artist used quick, strong brushstrokes. I liked the somber hues.

I bought this painting in 1991 for $18,000. It’s been appraised by two of the major auction houses at between $125,000 and $150,000. That’s an average annual appreciation of 7% to 8%. But I wouldn’t sell it for twice that price because (a) it’s a rare piece (an oil painting by a modern Mexican master), and (b) it still makes love to me every time I look at it.

Let me give you another example…

I have an oil painting in my office by a Pakistani artist. I bought it almost 30 years ago from a neighbor who was in financial straits. He sold it to me for $3,000. He told me it was worth more than that. But since I didn’t know the artist, $3,000 was as high as I was willing to go.

I liked it immediately. It was a large, abstracted image of a woman seated under the outstretched hand of a man. The bodies were aqua green. The background was black. The way one figure curled around the other appealed to some tender part of me. And yet, the impression was almost stark. More like an etching than an oil on canvas. The artist’s technique – drawing into wet paint with the hard end of the brush – was new to me. I was smitten.

I didn’t know who the artist was when I bought it. And perhaps the man who sold it to me didn’t know either. Or perhaps he did but didn’t realize that he was a rising star. Several years later, he tracked me down and offered to buy it back for $5,000. I demurred. A year later, he called me back and offered me $10,000. This continued on and off until I turned down $50,000.

By that time, we both had done our research and knew its market value.

I could probably sell it today for $60,000 wholesale. Or retail it and try to get $90,000. But I haven’t the slightest desire to do so for the same reasons I’m holding on to the Orozco.

Had I invested $3,000 in a stock index fund back then, it would have been worth about $50,000 today. In this case, my emotional attachment to this wonderful piece of art has given me a profit of between $10,000 and $40,000.

One last example:

In 2008, I bought a large painting by the CoBrA artist Jacques Doucet from a dealer in Amsterdam. (See “Did You Know,” below.) I didn’t particularly like this piece at the time. Its gloominess was more than even my usually gloomy temperament could connect with. But it was a strong painting, and I felt that the price I had negotiated – $20,000 – was a good one. I bought it and installed it in our “entertainment” room, a largish room we use for parties.

In 2016, someone called my partner at Ford Fine Art and offered to buy it for $40,000, doubling my money in 8 years. That was a nice 9% annualized return. In fact, the offered price was at a  premium because the buyer “loved” the image.

Meanwhile,  I had fallen in love with that painting. I couldn’t bring myself to sell it. So I turned down the offer, and I’m glad I did. I’m happy to have that painting in my collection so I can enjoy it now. And I expect that it will continue to appreciate at 8% to 10% annually.

The point is this: When it comes to holding for the long-term, it is easy to do with investment-grade art because you do fall in love with it. But with stocks and bonds, it’s not possible to have the same attachment. Instead, you get emotionally attached to its pricing.

And that makes you a bad investor.

The financial industry understands this. That’s why brokers and the investment media bombard investors with the real-time value of their stock holdings. The moment a stock drops, the investor knows it. He sees that big red loss on his account statement. For most investors, this creates anxiety. And frequently, they rid themselves of that anxiety by selling.

But investment-grade art is less reported upon. Therefore, the value is less subject to the emotional whipsaws of investors (and computer-based investment programs). Prices change from year to year, not day to day. This reduces the ups and downs in valuations. More important than that is the fact that most art investors, like me, are reluctant to sell their art for decades.

I believe this is the main reason I’ve done as well as I have with the better part of my collection. And it’s the reason I recommend investment-grade art to anyone interested in investing in art.

Falling in love with it is not a bad thing.

You get to have your cake and eat it too.

* This series of essays gives you an advance look at a new book that I’m working on, based on my experiences over the past 40+ years as a collector and investor in fine art. 

 

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“Tradition has it that whenever a group of people has tasted the lovely fruits of wealth, security, and prestige, it begins to find it more comfortable to believe in the obvious lie   and accept that it alone is entitled to privilege.” –Steven Biko

 

Are You “Privileged”? Yes? No? So What?

“Privilege” is a hot topic today – around the dining room table as well as in the mainstream media. One thing that I’ve noticed is that the people that have the strongest feelings about it seem to have the most trouble defining it.

Merriam-Webster defines privilege as “a right granted as a peculiar benefit, advantage, or favor.” As in, “Driving, my reckless son, is a privilege, not a right.”

This, of course, is not what privilege means to those in academia and the media that have made it an integral concept in social commentary. Privilege in that sense is the idea that in America there are certain groups (i.e., white men and to a lesser degree white women) that are entitled to social, economic, academic, and health advantages that (a) they did not earn and (b) are denied to other groups (people of color, women, and the LGBTQ community).

If you listen exclusively to Fox News, you might think this is a novel form of radical lunacy. It may have become wacky in recent years, but it’s hardly a new idea.

In The Souls of Black Folk (1903), W.E.B. Du Bois wrote that while African-Americans were very aware of white Americans and conscious of racial discrimination, white Americans hardly thought of African-Americans at all. Nor did they think much about the effects of racial discrimination. The social privileges white Americans enjoyed, he contended, included courtesy and deference, unimpeded admittance to all public functions, lenient treatment in court, and access to the best schools.

There is no question that white Americans did indeed enjoy all sorts of privileges denied to black Americans at the turn of the 20th century, when Du Bois published his famous book. The wackiness emerged in 1988, when Peggy McIntosh published an essay titled “White Privilege and Male Privilege.” In the essay, she listed 46 privileges that she believed she enjoyed as a white woman in the US. Among them: “If I need legal or medical help, my race will not work against me,” and “I do not have to educate my children to be aware of systemic racism.”

Her essay has since been credited with getting academics interested in the study of “privilege theory,” which includes the concept of intersectionality – i.e., that every individual has a mix of privileges and disadvantages depending on his gender, color, and sexual preference. Thus, a black woman has less privilege than a black man, and a black homosexual man has less privilege than a black heterosexual man.  And a white man… well, he sits on top of a stack of every social privilege there is.

One of the criticisms of intersectionality (advanced by the moral philosopher Lawrence Blum) is that its categories are too broad. It does not distinguish between Chinese, Japanese, Indians, and Vietnamese, for example. They are all grouped together as Asian-Americans, even though their relative economic, social, and academic success in America varies widely by group. (The same case is made with respect to black Americans by social philosopher Coleman Hughes, who notes the differences in advantages – i.e., achievement – by Caribbean blacks compared to African-Americans.)

Another criticism of intersectionality is that it is too narrowly focused. It does not include the obvious advantages of being good looking, for example, despite overwhelming evidence that physical beauty plays a major role in social, economic, and even academic achievement. Proponents of privilege theory also give a surprisingly low intersectionality “rating” to personal wealth, arguing that a wealthy black man or woman has less privilege than a poor white man or woman.

Also rarely discussed is being able-bodied and healthy – which anyone that lives a life so compromised recognizes as a huge privilege. And nowhere in the discussion is the recognition of perhaps the greatest privilege of all: having extraordinary intelligence.

It’s a messy area of inquiry, to be sure. And although it’s an easy concept to sell to college students, it’s much harder to get those on the higher end of the privilege scale to accept. (Especially if they are not particularly smart and well spoken, or if they are not, or were not, wealthy.)

Privilege theorists dislike having conversations about these sorts of privilege. They often argue that the mere mention of other privileges or disadvantages is invalid as it comes from people that are in some ways privileged themselves.

What they prefer to talk about is their views on a solution for social inequality – a solution that is usually a demand for advantages that are above and beyond what the privileged enjoy (e.g., preferential treatment in education, job placement, and social welfare assistance).

These are difficult conversations because there are all sorts of social inequities. And despite decades of legislation and trillions of dollars in funding, programs designed to fix the problem have failed to achieve their goals. In fact, the result has been greater inequality.

Still, one wants to believe that we can move towards a social environment where there is more equity in terms of such privileges. Or at least eliminate any actual institutional hindrances to people based on color, gender, or sexual preference.

So what can be done?

In a future essay, I’ll attempt to answer that question on a larger scale.

But on an individual basis, I think it’s fairly obvious that progress can be made, because it has been made. Virtually every proponent of privilege theory that is not a white man is proof of that.

What can you do? What can I do?

I think it starts with making an honest effort to recognize whatever privileges we have, as well as the ways – consciously and unconsciously – that we take advantage of them.

Here are 14 questions that might give you some insight into your own sense of privilege, regardless of your gender, race, sexual preference, income, etc.

 

  1. What goes through your head when you see a police car behind you?
  2. Do you feel underpaid and underappreciated at work – even though you are doing as well as your peers?
  3. If you’re a Liberal, do you believe that your views on political issues are morally superior to those of Conservatives?
  4. If you’re a Conservative, do you believe that your views on political issues are morally superior to those of Liberals?
  5. Do you think a really interesting book could be written about the stories your grandparents/ great grandparents told about coming to this country and pursuing the “American Dream”?
  6. Do you feel slighted when someone doesn’t remember your name?
  7. Do you think it’s okay to cut in line because you are in a rush… as long as you smile and apologize?
  8. Are you insulted when someone cuts in front of you… even if they smile and apologize?
  9. In terms of your lifestyle, would you describe the coronavirus shutdown as (a) annoying, (b) devastating, (c) Shutdown? What shutdown?
  10. In terms of your finances, would you describe the coronavirus shutdown as (a) annoying, (b) devastating, (c) Shutdown? What shutdown?
  11. Do you believe that your children are gifted?
  12. When someone who makes more money than you is paying the bill, do you feel justified in ordering a more expensive meal than you normally would?
  13. Do you believe that your lack of success in life has been caused by circumstances beyond your control?
  14. Do you believe that only a smugly privileged white male could have come up with these questions?

 

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Note: The following essay is an excerpt from the upcoming new and revised edition of Ready, Fire, Aim. 

 

Tribal Dynamics in Business 

 “The person who knows HOW will always have a job. The person who knows WHY will always be his boss.” – Alanis Morissette

When a start-up business grows, problems arise. Many entrepreneurs believe they can solve them by hiring additional people to deal with them. Sometimes that works. Often it doesn’t.

There are invisible challenges that come with a growing employee base – challenges that can hobble communication, reduce cash flow, and threaten profits. But if you understand the natural stages of entrepreneurial growth, you can anticipate and manage such challenges before they damage your business.

In The Tipping Point, Malcolm Gladwell looked at several anthropological studies of primitive societies that showed an interesting pattern. When tribes grew to more than 30 members, they tended to split into two smaller tribes, each with its own leader that was loyal to the original chieftain. One split into two. Two split into four. The smaller tribes were able to live and work together under the chieftain until the total size of the group exceeded about 150 individuals.

At that point, the unity of leadership broke down.

The researchers explained it this way: With no more than 30 tribe members, the chieftain has direct control over every one of them. When the group grows from 30 to 150, he can still exert significant influence over the entire group by communicating directly with his subordinates – the leaders of each smaller tribe. He maintins conrtol over the 150, but at a single degree of separation.

Once the group exceeds 150 tribe members, there is an additional degree of separation. The tribe leaders (and their followers) that report directly to him are still loyal to him. But the next level of leadership is now separated from him by three degrees. And their followers have little to no allegiance to him.

Contemporary research shows that a similar connection exists in the modern workplace. At three degrees of separation, communication breaks down.

There’s also some related research suggesting that there is an optimal number of employees that any executive can effectively manage: about six to eight.

When I first read about those studies, I was intrigued but doubtful. I was running a business that had about 300 employees. I felt sure that I was effectively managing them all. But when I took a closer look at what was actually going on, I had to admit that I was managing only six or seven people. And that I could identify, by name, fewer than 150 of our employees.

The more I observed, the more obvious it was that I was managing within that same ancient, tribal hierarchy. The success we were having was the result of making the connections between each level of leadership work. The failures we were experiencing were the result of broken links down the line of command, communication, and supervision.

 

Keeping on Top of the Expanding Hierarchy 

In a typical start-up business, the founder hires a handful of people to help him get it off the ground. There are seldom strict job descriptions or formal titles. Everyone is expected to do whatever needs to be done to move the company forward.

As the business grows, some sort of division of labor takes place. The founder puts one person charge of sales and marketing, another in charge of research and development, another in charge of production, another in charge of customer service, and so on.

At this point, the business may have, say, 50 employees. The founder feels no need to “manage” all 50 of them. He trusts his original team members to do that.

Although most of the employees do not report to him, he knows who these people are because he interacts with them – casually, perhaps – almost every week. These second-tier employees understand what their managers want, but they also understand what he wants. They have a sense of how he wants the business to grow. The smart ones can satisfy their own managers’ goals and also cater, in some way, to his ambitions.

But the business keeps growing. The marketing guy hires an SEO expert and a direct-response whiz. The sales gal hires six hungry salespeople. The guy in charge of customer service hires 12 reps to handle the increased volume of sales. Before long, the business has 100 or 150 employees, and some things are not running as smoothly as they were before.

Communication between the founder and his original team is still as close as it ever was. And the 40 to 50 employees that report to them are still working towards his overall agenda. But the other 50 to 100 employees have no idea what his ideas are. They rarely speak to him. They hardly know him at all.

By the time these third-tier employees move into management positions and start hiring and managing their own next-tier employees, there’s a good chance that they will be passing on their own, not the founder’s, core beliefs.

And if this continues unchecked, by the time the company has several hundred employees the “company culture” that was established by the founder is all but a distant memory.

This is not always a bad thing. If the founder is smart enough to hire superstars – smart, hardworking people that hire more superstars and pass down his ideas clearly and faithfully to them – the business can grow quickly and safely. But that is not the natural pattern of business growth. The natural pattern is entropy: starting with clarity and comprehension and then degrading into confusion and chaos.

There are traditional ways to curtail this sort of degeneration – procedures and protocols that are practiced in most large businesses and no doubt taught in most business schools. I’m referring to meetings and memos, reports and charts, training programs and employee manuals, retreats and seminars, and so on.

If you are a natural-born entrepreneur, you will loathe such solutions, as I did. But if you ignore them completely, I’m sorry to say, you will regret it.

I have spent my entire career rebuffing every effort to corportize every business I owned or ran or consulted with. And though I have had to concede that these remote-control management methods become to some extent necessary as a business grows, none of them can solve the problems caused by growth if the founder is not aware of the damage they do.

Corporate management is inherently anti-growth because it is designed for control. You cannot simply hire corporate managers and let them do what they’ve been trained to do. They will suck the marrow out of your business. They will solve the problems caused by growth by regulating, monitoring, measuring, and systemitizing everything they can get their hands on.

Of course, this is not true for every corporate manager. It is true only for nine out of 10.

So what can you do?

I don’t think you’ll find an answer in the Harvard Business Review. (I’ve been reading it for years and I haven’t seen one there.)

I’ll tell you what I have done.

First and foremost, I stay keenly aware of the primary objective of the business depending on its stage of growth. If it is proliferating products or advertising campaigns, I make sure that everyone that reports to me understands that his job is to support that primary objective, not to build out his domain in some way that suits his particular dreams.

Second, while obeying Pareto’s 80/20 Principle and giving 80% of my time and attention to the business’s primary challenge, I take responsibity for everything else.

If the business is in Stage One or Stage Two, I push hardest on cash flow and sales growth and product development. But I do not ignore or in any way denigrate operations and fulfillment and customer service and accounting. I make it clear to those that are running those departments that I expect excellence from them. I warn them that my lack of attention does not mean I don’t care what they are doing. On the contrary, I tell them, their jobs are vital to the business, and their responsibility to run those departments well is heightened by my lack of attention. I tell them that when we meet (usually once a month), I expect them to show me good numbers and be able to answer, with precision, any questions I have.

Meanwhile, no matter how strong those numbers are, I assume that their operations are falling apart, even when I have no reason to think so. I’ve been fooled before by slick reporting and positive presentations – and paid the price.

This is my personal approach. But it is based on the fact that, as I said, the natural pattern of business growth is entropy. It is nothing more or less than acknowledging that growth will always cause chaos, and that unless you constantly and continuously exert energy against chaos, entropy will out.

In other words, I obey Pareto’s Principle in my dealings with the top one or two priorities of the business at whatever stage it’s in… and I adhere to Murphy’s Law for everything else.

 

 

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“Don’t expect others to listen to what you have to say unless what you have to say is interesting to others.” – Michael Masterson

 

If You’re Trying to Impress Me, Don’t Do This

He had been strongly recommended for the job. And so I was expecting a sharp, take-charge person. Instead, when I took his call, I got this:

“I’ve been involved in strategically important roles with communications companies for 25 years. Throughout, I’ve focused on my core competencies, building brand recognition and interfaces with key personnel.”

To which I mentally replied: “Huh?”

He went on…

“It’s been a personal paradigm of mine that quality control and dynamic leadership are essentials in today’s globalized business environment, and that’s what I feel I can bring to any company I work for.”

I had already made an initial assessment: “This guy is full of shit.”

But, knowing myself to be a person that often rushes to judgment,  I tried to keep the conversation going.

“So,” I said, “what, exactly, have you been doing all these years?”

“Bringing in a bottom line and achieving optimal results have always been goals that resonated with me.”

“That’s enough,” I thought. “I can’t take any more.”

I opened and shut my desk drawer loudly to feign some sort of activity in my office.

“I’m sorry to do this,” I said. “But I have to jump off the phone to handle an emergency. I enjoyed talking to you. I’ll be sure to look at your resume and get back to you if something comes up that meets your qualifications.”

And with that, I bid farewell to this young man. And he, whether he knew it or not, bid farewell to any chance he had of ever working for me.

In their book Why Business People Speak Like Idiots, authors Fugere, Hardaway, and Warshawsky say there are three reasons executives – and people applying for management positions – sometimes speak like this.

  1. Their focus is on themselves, rather than on the person they’re speaking to. “When obscurity pollutes someone’s communications it’s often because the… goal is to impress and not to inform.”

 

  1. They fear using concrete language, because saying exactly what they mean can make it hard to wiggle out of commitments. “Liability scares [some people], so they add endless phrases to qualify [their] views, acknowledging everything from prevailing weather conditions to the 12 reasons we can’t make a decision now.”

 

  1. They want to elevate and even romanticize their thoughts and deeds, because they are afraid they aren’t impressive. They do so by using lofty language that disguises the mundane truth. They are afraid to appear ordinary. Their solution is to attempt to bamboozle everyone they speak with – and particularly those with power.

 

This is a very bad strategy. It’s basically the opposite of what a job seeker should do.

When applying for a job, only three things really matter to your prospective employer:

* What you know (your skill set)

* Who you are (your integrity)

* How you can help him (your work ethic)

Pretending to know things you don’t is a waste of your time, because you will be found out. Getting tossed onto the street after only a few weeks on the job is both embarrassing and an ugly blemish on your work history.

You can demonstrate your good character by being honest from the outset. Be candid about what you know and what you have done. But make it clear that you are confident you can quickly learn to do anything that is required of you.

Most importantly, you must understand this: In granting you an interview, your future employer is trying to find out if you can help him solve his problems and grow his business.

He isn’t looking to be impressed. He’s looking for someone who can make his life easier by doing a great job. Your job during the interview is to sell yourself as being that person.

And the first rule of successfully selling yourself is to make sure you’ve got the basics down pat:

* You must be good at something – quite good.

* That something must be useful to the success of the business you are attempting to work for.

If you’re a longtime reader of mine, you already know what I mean by that: It must be some financially valued skill. Generally speaking, that’s one of four things: marketing, selling, creating profitable products, or managing profits. (I’ve written about these skills many times – most recently, here.)

* You must prove that you are good.

And then you must deliver.

 

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Fine Art As a Long-Term Investment* 

“There’s something to be said about the art-industrial complex, the collectors who recognize that your work has some sort of future economic value.” – Kehinde Wiley

 

In 1989, a triptych by Francis Bacon sold for $7 million.

In 2013, a similar piece by Bacon sold for almost $140 million. Assuming the two pieces are roughly the same (a fair assumption), that amounts to a profit of more than $130 million in 24 years.

In terms of compound annual growth, it equates to a bit more than 13%. And that’s better than the stock market’s annualized return (just over 10% annually) for that same period.

In my first essay in this series, I made the broad case for why you should consider investing in art: If you invest wisely, you can do very well by earning a return on your money that is about as good as stocks but with a lot less volatility.

Today, I’m going to explain why so many ordinary, “amateur” art lovers – people who are not necessarily financially savvy – have, nevertheless, seen their art holdings appreciate amazingly, leaving them and their heirs immensely rich.

Let’s begin with this…

 

A Fundamental Difference 

There is an important difference between the psychology of the usual stock investor and that of the usual art collector.

The stock investor is motivated by a desire to build wealth. He buys stocks hoping they will grow in value and thereby contribute to his net worth. The art collector is motivated primarily by an emotional attachment to art and art collecting. She may hope to see her art collection appreciate in value, but her motivation in buying art is more complicated.

When I started buying Coca-Cola stock, for example, I didn’t buy it because I liked the taste of Coke. And I certainly didn’t ask for a stock certificate so I could hang it on my wall. I bought shares in Coca-Cola because I believed they would appreciate in value while paying me good dividends for as long as I held them. I bought them to help me grow my wealth.

When I bought my first watercolor by Diego Rivera, I was aware that I was buying the work of an important 20th Century modernist painter. But my motivation for buying it wasn’t its potential for appreciating. It was the desire I had to own it, to have it and keep it, and to display it and look at it.

I bought it because I had fallen in love with Rivera’s artistry and his place in art history. I wanted to show my friends – by hanging his work on my walls – that this master painter was, in some way, a part of my life.

 

The Sorry Psychology of the Individual Investor 

Although investors buy stocks for the clear and single purpose of increasing their wealth, they don’t do nearly as well as you might think.

According to countless studies, individual investors – even the “sensible” ones who buy serious companies like Coca-Cola – make far less on stocks and bonds than they should. This is also true of mutual fund investors and even of people who invest in index funds.

Index funds are mutual funds that track the market. So how can investors do worse than the market if they are investing in the market?

The reason, these studies show, is in their psychology.

Individual investors have a tendency to sell their stocks when  prices are dropping and buy into the market when prices are rising. This, everyone knows, is not the way to optimize a stock market portfolio. These investors violate good sense because of their emotions. But they are not attached to the stocks per se; they are attached to the fluctuations of their pricing.

In other words, they are no different than art collectors in their tendency to let emotional attachments rule them, but they attach their emotions to the wrong thing.

 

Art Collectors Are the Same but Different 

That explains why so many stock investors generally do so poorly. But why is it that some art lovers – even those who have, as I said, no financial acumen at all – often make gobs of money collecting art?

To answer that question, we must first understand something about the value history of fine art.

According to Kyle Sommer of JPMorgan Chase, “Art tends to move in slow and long-term cycles. Looking at performance on a risk-adjusted basis [returns divided by standard deviation] over the last 50 years, the Mei Moses World All Art Index matched that of the S&P 500 index. On a 25-year basis, the Mei Moses World All Art Index looked relatively strong, outpacing the MSCI EAFE as well as the S&P 500.” [The MSCI EAFE is an equity index that measures the performance of markets outside the US and Canada.]

So, one answer is that the ups and downs of art markets tend to be less dramatic than those of stocks. As a result, there is less opportunity for art collectors to overreact to price fluctuations, buying when they should be selling and selling when they should be buying.

But a more important answer is that art collectors are fundamentally less likely to make irrational buying/selling decisions when there happen to be fluctuations.

And that is because, as I said above, they form emotional attachments to the art itself. Their core desire is  to hold and keep the art object so they can enjoy it. Profiting from it is, at best, a secondary consideration.

If you know any art collectors, you have seen the truth of this in action. Art collectors love everything about collecting art. They love buying it at auctions, in galleries, and at exhibitions. They love putting it up on their walls and showing it to their friends. They love learning about it. And they love looking at it.

But if and when an opportunity to sell it comes up… that, they do not love.

I discovered this truth about yours truly when I opened my first art dealership – Morgan Fitzgerald Fine Art – nearly 30 years ago.

The first piece I put up for sale was a landscape by a mid-18th century French painter. I had bought it years earlier for $2,500. Its market value had doubled and I was offered $5,000 for it by a fellow collector. I should have been happy to complete my first sale at this price, but I was mortified. I told him my asking price was $7,500… and he quickly came back with a $7,500 offer. That convinced me that I should never sell the piece. It hangs on the wall of my library today.

No, art collectors don’t like selling their art. If the value of a particular piece goes up, they feel vindicated in their decision to buy it and their attachment to it becomes stronger. And if the price goes down, they feel upset not with the object or their decision to buy it but with the art market! (“These idiots don’t realize how great this painting is!”)

We collectors of art like the idea that the pieces we buy will appreciate because it makes us feel smart and it justifies our spending habits. But we don’t like selling our paintings and drawings and sculptures because we value the pride and pleasure they bring, and we don’t want to give that away.

That is our saving grace. And that is why so many amateur art collectors see the value of their collections rise so high. Our attachment to the thing rather than its price makes us natural  long-term investors. And long-term investing is always the smart, safe way to build real wealth.

 

* This series of essays gives you an advance look at a new book that I’m working on, based on my experiences over the past 40+ years as a collector and investor in fine art.  

 

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