2723: When Wealth Isn’t Real by Nick Maggiulli of Of Dollars and Data on Personal Financial Habits

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[00:01:07] at evernorth.com slash wonder. This is Optimal Finance Daily, episode 2723. When wealth isn't

[00:01:15] real by Nik Majulie of ofdollarsanddata.com. And I'm your host and personal finance enthusiast,

[00:01:23] Diana Merriam. Welcome back to Optimal Finance Daily, where every day I read and offer commentary

[00:01:29] on some of the best personal finance blogs on the web in about 10 minutes or less. So with that,

[00:01:35] let's get right to our next article as we optimize your life. When wealth isn't real

[00:01:45] by Nik Majulie of ofdollarsanddata.com. One of the biggest stories in finance over the past few years

[00:01:53] concerns Bill Hwang, the founder of Archegos Capital, who lost a record $20 billion in the

[00:01:59] span of two days. How did he do it? Leverage and lots of it. Hwang had levered up about 5x

[00:02:08] through an assortment of swap contracts on a handful of individual stocks. The payoffs on

[00:02:14] these swaps were relatively simple. If Hwang's stocks were up on the day, his banking partners

[00:02:20] paid him cash. And if they were down on the day, he paid them cash. From the beginning of 2021

[00:02:27] through mid-March, this strategy worked wonders for him. But then after experiencing such a severe

[00:02:33] decline across his portfolio, Hwang had to come up with significant amounts of cash to pay his

[00:02:39] banking partners. Unfortunately, he didn't have it. As a result, some of his banks took swift action

[00:02:46] and began liquidating his positions, causing further losses. As the liquidations mounted,

[00:02:53] Archegos entered a death spiral. Within two days, Hwang's fund had lost $20 billion.

[00:03:00] While it would be easy for me to write a post criticizing Hwang for using too much leverage,

[00:03:05] that idea isn't particularly interesting to me nor particularly helpful to you. Not only have

[00:03:11] I written about this topic before, but individual investors like you and I aren't allowed to borrow

[00:03:17] at these levels anyway. Warning against the use of 5x leverage would be like warning against the

[00:03:24] dangers of getting injured while playing in the NFL. It is a risk, but not one that 99.9% of people

[00:03:31] have to worry about. But what is intriguing about this story is what it illustrates about how we

[00:03:37] think about wealth. Based on what I've read, Hwang now holds the record for the fastest loss of

[00:03:43] wealth in history. Mark Zuckerberg once lost $16 billion in a single day after Facebook shares

[00:03:50] plunged by 19% in July of 2018. But that was an unrealized loss or on paper only. Since Zuckerberg

[00:03:59] didn't sell his shares and Facebook's share price is now 50% higher than it was before the decline,

[00:04:06] the loss doesn't really count. But I don't think Hwang's loss of $20 billion counts either.

[00:04:12] Because if Hwang had tried to get out of his positions in the days before they crashed,

[00:04:17] I doubt he would have been left with $20 billion or anywhere near that anyways. You can say the

[00:04:24] same thing about ultra-billionaires who have most of their wealth in one or a few assets.

[00:04:30] For example, Elon Musk currently owns over $100 billion worth of Tesla stock. If he decided to

[00:04:37] liquidate all of it, how much of that $100 billion do you think he could actually realize?

[00:04:43] I have no clue, but I doubt he gets away with more than $50 billion of it.

[00:04:48] In the process of selling his shares, Tesla's stock price would go into freefall. Not only

[00:04:55] would there be not enough buyers to support the price, but once investors found out that

[00:05:00] Musk was selling, many of them would lose confidence in the stock as well. Of course,

[00:05:05] Musk would never do such a ridiculous thing, but it illustrates how large sums of wealth

[00:05:10] are illusionary in the first place. So when we talk about Bill Hwang's $20 billion loss,

[00:05:17] we aren't really talking about the destruction of $20 billion in realized dollars. It's not like

[00:05:24] Hwang took $20 billion in cash and built a position up over time that eventually went up in flames.

[00:05:31] In fact, it's the opposite. He took a small amount of money and grew it very quickly by using

[00:05:37] increasing amounts of leverage. This wealth never really existed anywhere besides on paper.

[00:05:44] But isn't most wealth on paper though? Well, yes, but most people can realize that wealth.

[00:05:51] For example, if I decided to sell every asset I own tomorrow, I would be able to realize all of

[00:05:57] it at the market price without taking any significant haircut. Since I own small amounts

[00:06:03] of highly liquid assets, my choice to sell would have no material impact on the market price.

[00:06:09] This is probably true for 99.9% of people. However, for those that have larger amounts

[00:06:15] of wealth, especially in a liquid assets, that's when things become distorted. Yes,

[00:06:21] their wealth can be measured on paper, but they don't really know how much they have until they

[00:06:26] sell. History is filled with examples of ultra rich individuals who learned this lesson the hard way.

[00:06:33] That doesn't mean that Hwang's loss at Archegos is unimportant, but that it's probably less

[00:06:39] extraordinary than it initially appeared. Because in Hwang's case, very little of substance was

[00:06:45] actually lost. It's not like 20 billion of physical capital was destroyed or economic

[00:06:50] activity was reduced by 20 billion. No, his inflated assets were deflated and his true loss

[00:06:57] was much smaller. It would be like if you owned an aircraft leasing company with 10 Boeing 747s

[00:07:04] listed on your balance sheet at 400 million a piece or 4 billion in total. However, after COVID-19 hit,

[00:07:11] you discovered two things. One, your airplanes are now worth only 300 million a piece. And two,

[00:07:18] you had miscounted and actually only own nine Boeing 747s after all. Now your listed assets

[00:07:26] are worth 2.7 billion or 300 million times nine planes down from 4 billion. Did you just experience

[00:07:34] a $1.3 billion loss? No, you experienced a $900 million loss. Since one of your planes never

[00:07:42] existed in the first place, that additional 400 million was never really lost. This is kind of

[00:07:48] like what happened to Hwang and Archegos where the value of their individual positions were the

[00:07:53] equivalent of that extra non-existent airplane. Yes, this analogy isn't exactly correct, but it

[00:08:00] gets at the underlying idea. In some cases, wealth isn't what it seems. We can see it, we can count

[00:08:07] it, we can write it down on a piece of paper, but as soon as we go to touch it, it disappears,

[00:08:12] like a financial hologram, like something that never truly existed. While you may never experience

[00:08:19] any such thing during your lifetime, there will be people who you know who will. They will overvalue

[00:08:25] their assets. They'll believe their home or business or other asset are worth more than

[00:08:30] they really are. They'll make financial decisions based on this information too. But one day,

[00:08:36] they may realize the uncomfortable truth. Not all wealth is real. You just listened to the post

[00:08:45] titled, When Wealth Isn't Real by Nik Majulie of ofdollarsanddata.com and I'll be right back

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[00:10:44] This article made me think about how we value our assets. Think about it. How often do we

[00:10:49] inflate the value of our homes, our cars, or even our prized possessions? We see that Zestimate on

[00:10:56] Zillow or that Kelley Blue Book value and suddenly we're convinced that it's cold hard cash in our

[00:11:03] hands. But the truth is those numbers are just estimates and they don't always reflect what we

[00:11:09] could actually get if we tried to sell. In hot real estate markets, it's easy to get caught up

[00:11:14] in the frenzy and think our homes are worth way more than they actually are. But when it comes

[00:11:19] time to sell, we might be in for a rude awakening. I have a neighbor that tracks all the expenses of

[00:11:26] improvements he's making to his home. In his mind, if he spends $2,000 on new tile, that increases

[00:11:33] the value of his home by $2,000. But it doesn't really work like that. And it's not just homes.

[00:11:40] Think about all the stuff we accumulate over the years. Furniture, gadgets, collectibles. We assign

[00:11:46] sentimental value to those things, convincing ourselves they're worth more than they really are.

[00:11:51] But when push comes to shove, we might find that no one else sees them the same way we do.

[00:11:56] So while this article focuses on the high stakes world of finance, it's also a wake-up call for

[00:12:01] us regular folks to take a hard look at our own assets and make sure we're not overvaluing them.

[00:12:07] After all, it's better to be pleasantly surprised than bitterly disappointed when it comes time to

[00:12:12] cash in. And that's another edition of Optimal Finance Daily. Thank you for listening, and I'll

[00:12:18] be back with you tomorrow for another post. So I'll see you there where your optimal life awaits.