Note that there is nothing wrong with investing aggressively. Many families have done it with great success for many years. But aggressive investing leaves precious little margin for error. If you're driving your car at 40 miles per hour, a lot of bad things can happen on the road and you'll still have plenty of time to adjust. But at 80 miles per hour, you'd better be on high alert at all times. George III thought of himself as a far-above-average investor, but as we will see, he was confusing brilliance with a bull market.
The American Stock Market Turns Sour
The late 1960s had seen strong equity markets in the United States, but the year is now 1974 and it is mid-July. George III is 70 years old and has been overseeing the family investment portfolio from his office at Lawburn (the Titan family office) for many years.
George III considered himself to be an astute investor, and both under the local trust company and, later, under the bank, George believed that the family's capital had been well-managed. Following the Allied victory in World War II, the United States had become the world's most powerful country. It's main competitors at the timeâGermany, Japan, and Britainâhad all been devastated in the war and the U.S. economy expanded rapidly.
The American stock market had kept pace with this growth, so that even net of the family's rather heavy spendingâabout 5% of the capital's value every yearâthe portfolio had continued to grow in both nominal and real terms. Basically, since the end of World War II the U.S. stock market had been on a consistent upward march. During the decade of the 1950s, for example, the Dow rose from just over 200 to over 600. The surge slowed a bit in the 1960s, but even so the Dow rose to 800 during that decade, and there were several official bull markets late in the decade (1962â1966 and 1967â1968).
In 1972, the Dow Jones Industrial Average had gained 15%, and most investors believed that the good times would continue. The 1970s would be at least as good as the 1960s, and maybe as good as the 1950s. Time magazine, for example, in early January 1973, predicted that 1973 was âshaping up as a gilt-edged year.â1
But the prognosticators were badly off-target. On January 11, 1973, the Dow began a dive that would result in one of the worst bear markets in history. Over the following 699 days, through December 1974, the Dow dropped 45%. Making matters worse, inflation, which had been just over 3% in 1972, jumped to 12.3% in 1974. In other words, in inflation-adjusted terms the losses were even greater. And while the market was crashing, so was the U.S. economy, where GDP growth dropped from +7.2% in 1972 to â2.1% in 1974. (Matters were even worse elsewhere. The London FT 30 Index, a predecessor of today's FT 100 Index, dropped 73% during the bear market.)
All this stunned George III who, as noted earlier, had presided over two decades of excellent returns and who had forgotten that those returns were driven mainly by strong market conditions and not by his excellent investment judgment. As the markets continued to sink throughout 1973 and into 1974, George began to raise hell with his bank investment managers.
But those advisors believed that investors should think long term. Sure, the market was currently in a bear phase, their thinking went, but that wasn't a permanent condition. Sooner or later, the market would turn up again, and when it did, families like the Titans needed to be heavily exposed to stocks in order to take advantage of the rebound.
But the result of this thinking was that the bank was continually âaveraging down,â as George indignantly put it, selling good bonds to buy bad stocks. Whatever the bank bought, it promptly went down.
Quick Note
Here is a case of the family's advisor giving them reasonably good advice, but not couching it in terms the family could accept. Quarter-after-quarter of âaveraging downâ convinced George Titan that the bank didn't know what it was doing, that it was just operating on automatic pilot.
By the first quarter of 1974, George was getting questions from his wife and (adult) children about what was going on in the portfolio. They were naturally concerned that, as the value of their capital plummeted, their spending might have to be cut. In an effort to keep the pressure off, George III didn't cut the family's spending, but as a result, that spending grew and grew as a percentage of the capital that supported it.
As noted earlier, at the end of the 1960s the George III branch of the family had been spending 5% of its capital every year. This was too high, but George III was analogizing his family to the endowments of the nonprofit organizations on whose boards he served, most of which spent about 5% per year. But George had forgotten that nonprofit endowments don't pay taxes and that, typically, they are large enough to pay much lower investment management fees than families pay. Moreover, endowed institutions have a fallback in the event of poor outcomes: they can go out and raise more money. Try that as a family.
George's family should have been spending more like 3% of their capital each year, even in good times. But as the value of the portfolio plummeted throughout 1973 and 1974, and as the family's spending remained constant, the percentage they were spending grew and grew, causing the capital to decline even faster. By early summer of 1974, the George III branch of the Titan family was spending more than 8% of the portfolio's value.
The family's account managers at the bank were alarmed by the high spending, and they would sometimes (very gently) raise the issue with George III. But the patriarch's view was that it was none of the bank's business how much the family spent, and so the conversation went nowhere.
George III Makes a Fateful Decision
As his family's losses deepened, George III found himself losing sleep. He became difficult to live with, snapping at Mary and avoiding his friends. Finally, at the end of June 1974, George III took a room at the Rolling Rock Club, locked his door, and spent the better part of three days reviewing the performance of the family's portfolio under his managementâgoing all the way back to World War II.
As he worked his way forward from the war years to the present day, George noticed something he'd never focused on before. As mentioned above, immediately after the war everything went America's way. But this was because our competitors in Europe and Japan had been flattened in the war while America was hardly touched.
By the 1960s, while things still looked good in America and while the market was still moving up, albeit not so sharply, it was obvious to George that looks were deceiving. Europe and Japan were recovering rapidly, thanks in many cases to generous help from America, and competition from those quarters was beginning to bite. Already steel from Germany and Japan was beginning to show up in the United States, and it was not only cheaper than our own steel, it was in many cases of better quality.
American investors, lulled into somnolence by two decades of easy money, had been asleep at the switch. But in the early 1970s those investors woke up and realized that America had fallen behind Europe and Japan, to say nothing of a resurgent Soviet Union. Suddenly, no one wanted to own stocks.
George returned to his office and scheduled a family meeting for mid-July. That meeting would also be held at the Rolling Rock Club, a tony country club founded by Pittsburgh's Mellon family. George had reserved a secluded meeting room behind the Card Room, most easily a...
