Happy Final Tax Filing Day everyone. How charitable do you feel right now?
My accountant filed for an extension for me, so I’ll let you know in mid-October how I’m feeling, thanks for asking.
Anyway, one of the potential big changes resulting from the 2017 Tax Reform is the treatment of household charitable contributions, starting in 2018. Quite possibly that changes how much we all give every year.
At tax filing time, taxpayers may list all their charitable contributions and receive a deduction from income for that contribution. If for example I give $1,000 to a charitable association like the Society For Redundancy Society, and I am in the 25 percent tax bracket, I could expect to receive a $250 reduction in my taxes at tax filing time. A few other categories of things, like mortgage interest, get similarly rewarded via reduced taxes. It has often made sense to go to the hassle of listing these tax deductions, as long as they are larger than my household’s standard deduction, previously set at $12,700.
I can still do that, but the new tax policy passed in 2017 changes my incentive for itemizing deductions.
Fewer of us will itemize deductions because the standard deduction – which allows people to skip itemizing – nearly doubled in 2018, up to $12,000 for individuals and $24,000 for couples. I’d have to give a lot more money to the Society for Redundancy Society, in addition to my mortgage interest deduction, for my charitable contribution to have a specific effect on how much I pay in taxes.
The Tax Policy Center estimates that the number of tax filers claiming itemized deductions for charity will drop by 50 percent in 2018 versus 2017. That by itself is probably a helpful increase in efficiency, since fewer itemized deductions means simpler tax filing for taxpayers as well as less work for the IRS.
At the same time, however, the Tax Policy Center estimates charitable giving will drop by 5 percent as a result of fewer households receiving the tax incentive from itemized deductions. That’s potentially problematic. Charitable donations in the US totaled an estimated $373 billion in 2016, so a 5 percent drop ($18.65 billion) is a lot of lost philanthropic dollars.
I followed up with Dr. Beebe to get a fuller picture of what we should expect in terms of charitable giving in response to changes in the tax law in general, and changes due to higher household standard deductions in particular. In the course of the conversation I learned a few things about changing views among economists on tax policy and charitable giving.
Before the 1990s, economists had developed a consensus around the belief that incentivizing charitable giving through taxes resulted in greater revenue for charitable organizations than was given up in terms of lost government revenue. The result would be more money overall in society for social services for example, if charitable giving increased more than tax revenue decreased. So that tax incentive toward charitable giving was believed by economists to be efficient.
That earlier view among economists also happened to align with a certain a view of American society as unique in the world. What I mean by that is the particular pride we take in what Alexis de Tocqueville noted as a strong civil society and the tendency to solve problems without government intervention.
De Tocqueville famously wrote in Democracy in America in 1835, “Americans group together to hold fetes, found seminaries, build inns, construct churches, distribute books, dispatch missionaries to the antipodes.” De Tocqueville continued “They establish hospitals, prisons, schools by the same method. Finally, if they wish to highlight a truth or develop an opinion by the encouragement of a great example, they form an association.” Tocqueville argued that what we call charitable organizations is a key component of what makes democracy work in the United States.
Dr. Beebe’s paper notes an estimated 80 percent of global private philanthropic giving for developmental purposes came from US foundations in 2015, indicating that our unique civil society approach – rather than solving problems by government intervention – continues more than 180 years after de Tocqueville’s book described us.
I mention all this to say that charitable giving is at the heart of US political culture, and economists previously believed we had good reason to support that with tax law.
Since the 1990s, however, either because of better data or better measuring techniques, economists have come to believe that the effects of tax policy on charitable giving is much more mixed. We know less than we thought we knew before. But we know some more precise things, according to Dr. Beebe.
Certain types of giving, to one’s church for example as well as giving among lower-income households, is not driven by tax law. That happens despite changes in tax incentives, and we wouldn’t expect that to drop with a higher deduction. Dr. Beebe points out, however, that giving from upper income and upper wealth households tends to be much more responsive to changes in tax incentives.
It’s from upper income households that economists believe the drop in charitable giving will come.
Dr. Beebe estimates that the expected drop in charitable giving will mostly come – maybe 70 percent – from upper income households responding to the higher standard deduction. A smaller, but still notable effect – maybe 30 percent – on charitable giving will come from changes that create a disincentive for wealthier folks from making bequests in order to reduce their estate tax bill.
A 5 percent drop in charitable giving next year isn’t the end of the world. But if you appreciate de Tocqueville’s description, it’s just a small chipping away of something at the foundation of American democracy.
A version of this post ran in the San Antonio Express News and Houston Chronicle.
In response to the extraordinary needs of their city after Hurricane Harvey, Houston philanthropists John and Laura Arnold first gave $5 million to the “Greater Houston Community Foundation’s Hurricane Harvey Relief Fund,” aka the “Mayor’s Fund.”
Following that gift, however, the couple made a second $5 million gift to an atypical organization named GiveDirectly one that had neither previously operated in the United States, nor had worked on natural disasters.
Through their philanthropy, the Arnolds are posing an important question – what’s the best way to deliver resources to a hard-hit community after a natural disaster like Hurricane Harvey? We won’t necessarily all agree, nor is there just “one way,” but it’s an important question to keep asking.
Before Harvey, GiveDirectly had only worked in East Africa. Their mission is to give money, unconditionally, to the most poverty-stricken people in the world. They don’t do “development work” the regular way by building clean-water wells, or houses, or hospitals, or give goats or chickens or food or clothing or solar-powered generators. They do “unconditional cash transfers” (UCT), and they trust the recipients know best how to use it to alleviate their own poverty.
GiveDirectly’s operation in Texas following Harvey is a test of whether that theory of “unconditional cash only, not stuff” could apply to disaster-relief in the United States.
As John Arnold explained to me, he and his wife’s thought process for supporting GiveDirectly was as follows:
First, the private sector can do a great job with the logistics of delivering needed goods and services to Texans, even in the face of catastrophic flooding, as occurred following Harvey. He marveled at watching ten fully-stocked Wal-Mart tractor trailers arriving early after the rains, ready to supply Houstonians.
Second, the missing piece for many people hurt by the storm is simply: money. Wal-Mart, Arnold reasoned, will figure out how to provide the right stuff, as long as people have money in their hands to pay for that stuff.
Third, the best relief is probably a group that can just deliver money into the hands of people who need it.
“Everybody’s highest priority is different,”
Arnold told me.
“Some people’s car was damaged and they can’t get to work. Others had their work interrupted and they just need temporarily help to cover next month’s rent.”
So the Arnolds chose GiveDirectly for their $5 million.
Funded by the Arnolds and other donors, GiveDirectly set up a plan to deliver pre-loaded Visa debit-cards with a $1,500 value to impacted households in Texas. In Rose City, a badly-flooded town next to Beaumont that I wrote about last week, GiveDirectly arrived in October to deliver $1,500 to each one of the estimated 210 households, without conditions.
Rose City Mayor Bonnie Stephenson confirmed working with GiveDirectly to reach substantially all households in her town, holding town meetings and community gatherings to help get the word out. GiveDirectly reports successfully distributing 180 cards to the intended 210 households, according Catherine Diao, Communcations Lead for the organization.. In a few households, says Diao, they simply could not locate eligible recipients despite multiple efforts to do so.
GiveDirectly next expanded its giving to the Lakewood area of Northeast Houston. As of now they have handed out and estimated total of 1,200 pre-loaded cards of $1,500 each, with the intention of distributing up to 3,000 total.
Their methods are still evolving. In Rose City, the cards were meant to be “universal,” meaning that everyone with a household address in town qualified for the funds. In the Northeast section of Houston, GiveDirectly is attempting to target the $1,500 pre-paid Visa cards to only those who have demonstrated property losses.
As John Arnold explained, a classic problem of relief is to design a system that is restrictive enough to prevent fraud, but not overly restrictive that it prevents delivery of resources. It’s safe to say no system is perfect.
The normal model of disaster relief is that a combination of the federal government (primarily FEMA), big organizations like the Red Cross, and state and local officials coordinate major resources, while more locally-focused groups fill in the gaps with stuff at hand, like food, water and blankets.
Problems plague each of these responses, of course. One recurring problem with the smaller “stuff at hand” solution is that the stuff may not reflect what people actually need most, at any given time. The appeal of UCT is that recipients decide exactly what they need, not donors.
At the larger scale, FEMA and Red Cross have far more capacity than local groups to deliver resources. But one recurring complaint about the bigger organizations is whether the big infrastructure and big dollars are efficiently spent. In addition, qualifying for substantial FEMA grants, or even $400 Red Cross payments, involves engaging with a bureaucracy that may seem confusing or overly strict, a bundle of “red tape,” to use a word I heard repeatedly from folks in Rose City, including Mayor Stephenson. GiveDirectly’s attempt with UCT is to make delivery simple.
GiveDirectly, by their own estimation, regards their efforts in Texas as exploratory, but in line with their dual purpose of giving relief and pushing for more efficiency among relief organizations.
As President and co-founder of GiveDirectly Michael Faye wrote me,
“Recipients prefer cash and are frustrated with the opacity and efficiency of the traditional options, and want a direct giving alternative. With donors wanting it, and recipients preferring it, why shouldn’t it exist? At worst, it’ll help people rebuild their lives, and at best, it will force a conversation and potentially shift the [philanthropic] sector.”
John Arnold also explicitly called out the dual purpose of his gifts. First, there’s the charitable reason, which he defined as just providing help to people in Texas who need it the most. Second, there’s the philanthropic reason, which he defines as attempting to be thoughtful about solving problems at their root causes. The combination of charity and philanthropy, I gathered from our conversation, is why GiveDirectly appealed to him and his wife.
For people with resources to give for Hurricane Harvey relief, an important question has arisen this month: How do I decide where to give money? Among people who live in coastal Texas cities and towns, many donors probably already choose an organization they personally know, with a well-defined and limited mission, a local network of workers, and specific knowledge of affected communities. Think church groups, local food banks, self-organizing neighborhoods teams for clean-up and rebuilding, or local foundations.
For Americans without specific ties to the area, however, the first recipient of giving is often the Red Cross. And the Red Cross, as the largest non-governmental disaster relief organization, has come in for special scrutiny in recent years, following natural disasters.
One charitable interpretation of these reports is that, as the highest profile organization in any business that inevitably involves improvisation and mistakes – specifically, emergency disaster relief – the Red Cross becomes just the biggest target of criticism. Everybody makes mistakes in the midst of disaster, the thought goes, and bigger organizations make bigger mistakes and come in for bigger criticism.
A less charitable interpretation of the Pro Publica investigations is that there’s something inherently worse about the Red Cross than other, smaller, relief groups. A summary critique from Pro Publica is that there’s a lot public relations “show” from the Red Cross instead of a lot of actual relief on the ground, in these past disasters.
If you haven’t read the Pro Publica investigative reports from 2014 and 2015, well, they are scathing. Their deep investigations include a trove of internal documents produced by the Red Cross itself, which were also damning.
After Hurricane Sandy, for example, there was the deployment of 40% of emergency response vehicles to non-critical areas, in order to make them visible during press conferences on Staten Island. After Hurricane Isaac, a Red Cross truck driver reported being told to drove around the affected areas specifically to give the appearance of activity, but with no particular mission beyond public relations. There was the deployment of volunteers into the post-Sandy disaster who themselves were not fit enough to accomplish physically demanding tasks. In Haiti, Pro Publica reported in 2015, the Red Cross raised half a billion dollars to build housing after a devastating earthquake, but only 6 houses ever got built.
Less systemically, but still indicating ham-handedness, there was the truck full of pork lunches delivered to the Jewish retirement-community high rise in New Jersey after Sandy.
One of the recurring arguments in the ongoing aftermath of reporting on the Red Cross and other relief charities is what percentage of an annual budget gets dedicated to “programs” (the actual relief effort delivery) versus ”overhead,” or organization costs. The Red Cross self-reports that 91 percent of its $2.7 billion in 2016 went to programs, with only 9 percent dedicated to overhead, and that figure represents its typical spending in other years as well.
The non-profit reporting group Charity Navigator gives the Red Cross a respectable three out of four stars on their scale, for a combination of financial efficiency as well as transparency. Pro Publica itself challenges the 9 percent overhead figures, however, citing sub-contracting relief work to other organizations, which tack on their own administrative overhead costs, and thus obscuring the issue.
The larger point may not be arguing over what precise level of overhead costs is appropriate for what organization or what mission. Reasonable people could disagree on these issues. The larger point is probably whether they fulfill a needed role, at a crucial time, better than anyone else.
And maybe for a high-profile organization like the Red Cross, the key is whether they respond to past criticism by improving their delivery of services in the wake of Hurricane Harvey. Do they inarguably succeed at providing the best relief instead of the best public relations efforts? Time will tell.
I don’t even think that all public relations efforts are bad. In the last few weeks we’ve all watched elected public officials and other high-profile personalities conspicuously “helping” in front of cameras during post-Harvey relief, and this “help” is both an obvious public relations ploy but also an important show of societal solidarity. Healing includes seeing our leaders see the pain and chaos directly, and us believing that at some level our leaders “get it.” We accept a certain amount of show, to go along with the actual work, among government leaders.
With a non-governmental relief group like the Red Cross, however, maybe we expect a higher ratio of actual help to public relations show, since their role is less a symbol of our collective society and more about just delivering results? I don’t know exactly what’s fair.
When I dropped a few bucks into the collection bowl at my CrossFit gym to help send a fellow gym-buddy with his food truck to the Texas coast to provide hot meals, I expected a certain amateurish approach, producing a limited impact with our limited resources. If I elect to send money to a huge professional organization like the Red Cross, I expect an almost militaristic deployment, efficiently solving huge needs with their vast resources.
Right now, given all the immediate needs, all help is appreciated without an overly critical eye on “efficiency.” But as the post-Harvey recovery stretches into months and then years, we’ll need an assessment of which large groups delivered best on their promise of disaster relief.
It’s probably too early to assess, just two weeks after Hurricane Harvey passed through the region, to know which organizations made the biggest impact and which organizations did not. A natural question we will want to keep asking ourselves, however, is who helped the most with our dollars, so that we know who to support now, and in the future.
If you face the high-quality problem of finishing your life with too much money, you’ve probably already figured out that three groups, and three groups only, get your surplus: The government, your family, and your preferred charities. Of these, we typically all agree about leaving the lowest legal amount to the government. Then we face tremendous stress about how to allocate our fortune between the other two.
This post not only nudges you toward door number three (your favorite charities!) but advocates a tax-efficient, low-cost way to do it, available to people of even modest means.
But first, the problem of children.
Many choose to prioritize their children or relatives first, which is fine, whatever, it’s your dollar. My own personal starting point about inheritance discussions is this: children do not deserve free money.
However, I realize we’re not going to all agree on that one, and I’m not (yet) in a position to vastly increase federal estate taxes.
Meanwhile, what do people facing a wealth surplus worry about? Merrill Lynch – in a 2015 report titled “How Much Should I Give To My Family? On the Risks and Rewards of Giving ” – found two problems when they surveyed their high net-worth clients. First, 42 percent of respondents plan to pass on their assets only AFTER their death, rather than while they’re alive. Second, more than 60 percent of high net-worth clients worried about the potential negative effects of inherited wealth on their children.
The problem, as Merrill Lynch and other financial advisors will likely agree, is that those findings bump up against two well-known estate-planning principles.
First, giving away money during your lifetime – rather than after your death – is the most efficient way to minimize taxes on transferring your wealth. And 42 percent of Merrill Lynch respondents weren’t planning that. So now all we need is a (tax-efficient, low-cost) way to give money away while you’re still alive. Keep reading.
Second, the key to lowering stress in estate planning is to put your personal values in the center of the plan. More than 60 percent are stressed about the tension between their values and their children’s values, which means they have not sufficiently figured out answers to the questions: What do you believe in? What do you stand for? What people or organizations or values represent the highest expressions of meaning in your life?
If it’s all about your children, cool, give them the money. If you have other values you want to express as well, however, let’s talk about donor-advised funds for a moment.
Donor Advised Funds
What’s the best way to give away money during your lifetime? Although that’s too broad a question, I’m going to opine anyway. A very good way – surprisingly both affordable and flexible – seems to be donor-advised funds (DAF).
You should obviously be cautious when taking tax, legal, and financial advice from someone who writes a blog, but it seems to me a DAF offers tremendous advantages in a simpler – and therefore lower cost – way than a foundation or trust, especially if your estate will not require the Full Monty of intergenerational wealth planning.
Most of the major brokerage houses and investment firms offer donor-advised funds, which appear to a nice, low-cost way to accomplish an expression of your values in your lifetime – and beyond! – without setting up a potentially complicated and expensive legal structure, such as a foundation or trust.
Here are some basics when you contribute to a DAF:
You can enjoy a charitable gift tax benefit in the year of your gift.
Your assets continue to grow in value, tax free, over time.
You don’t have to designate all of your charitable beneficiaries now, because your appointed trustees – such as you and your children – can designate gifts to charities over time.
Giving involves a simple call or note to the brokerage firm, which then confirms the recipient charity is legit. After verifying that, the money for your donation goes out to the charity in just a few days’ time.
Mostly what the DAF gives you, as I view it, is time to enjoy giving while you are still alive. That’s time to make future decisions and hold conversations with your children or other designated trustees about your values. I also like the idea that you get a chance, during your lifetime, to observe and reflect on the effect of your gift. Is the charity actually fulfilling its mission? Is it fulfilling your mission? And then, why not actually get thanked in person, rather than the grimmer path of grateful recipients having to thank a plaque with your name on it?
I looked up three different well-known, name-brand brokerage companies to check out fees and account minimums on their DAFs.
All three charged 0.6% annual fees on DAFs, with reduced fees on accounts over $500,000.
The National Philanthropic Trust reports the average DAF reached $296,701 in 2014. but clearly you can open up one of these funds for far less. Two of the three brokerage firms I looked at offer opening account minimums of $5,000, while a third required a $25,000 minimum.
What that says to me is that tax-advantaged, value-driven charitable giving of your wealth – both in your lifetime and beyond – isn’t something only available to the extremely wealthy. Instead, pretty sophisticated philanthropic vehicles are available to Main Street investors, who just happen to have a little surplus.
You can give your assets to the DAF this year, enjoying all available tax advantages of that gift now, and spend future years giving to worthy causes.
You can do this over time in consultation with your children or designated trustees, affording you the satisfaction of giving, as well as the pleasure of talking about and expressing your highest values.
I feel like there are lessons about philanthropy in John Paulson’s $400 million gift to Harvard that I haven’t seen explained yet.
I don’t know John Paulson (maybe that’s already obvious?) but I feel like I know a little bit about how he thinks, having worked with, for, and as a mortgage bond professional, and with, for, and as a hedge fund investor.
John Paulson is most famous for making $4 Billion in 2008 via the The Greatest Trade Ever, shorting sub-prime mortgage bonds through his eponymous hedge fund. Last week he shot back into the public eye for his philanthropy and the subsequent negative reactions to his gift, spearheaded by smart guys like Malcolm Gladwell and other pundits.
In reviewing reactions to his $400 million gift to Harvard’s School of Engineering and Applied Sciences, I’m struck that I haven’t heard an accurate description of Paulson’s reasoning, based on what we know about him. The overwhelming reaction of the smart guys is to complain that Harvard is one of the least deserving ‘charities’ around. Further, the conventional-wisdom smart guys complain, couldn’t he have found a charity to address poverty, or something more worthy, rather than make an already elite institution more elite?
Having worked with guys like Paulson, and understanding a bit about his professional background and track record, I know the following four things:
1. He’s focused on value. He would prefer to die rather than overpay for something.
What I mean by that is that when Paulson pays $400 million to Harvard for naming rights and also to get credit for the largest gift ever to a University, he’s not being careless about the amount. If he could get that kind of value for $375 million, he would have paid $375 million, not $400 million. Whatever the ultimate purpose of the gift (and I don’t pretend to know that, any more than I really know the inner thoughts of Paulson) he didn’t come up with $400 million by accident. And whatever his reasoning, and no matter how large the headline number, he was not overpaying.
2. He wants the #1 best thing. Not tenth best, not seventh best, not second best. Just the number one best thing. This next statement may sound flippant, and it may sound like I’m being Harvard-proud, and I really don’t mean to be. But if Paulson felt like he could have gotten what he wanted by donating to Dartmouth he would have done it. He chose Harvard because it struck him as the best.
Giving to ‘the best,’ obviously, is a different mind-set than giving to the ‘most worthy.’
Paulson’s critics feel he should have found a worthier cause than Harvard. Maybe so. But is that theoretical preferable charity the absolute best in the world at what they do? I suspect that criteria mattered to Paulson, as it does to many people who think like Paulson.
3. Risks matter tremendously. If he’s going to pay good money, the risks should be minimized. I think this point is probably key to why he didn’t give $400 million to a program to combat poverty, or end malaria, or whatever it is that Gladwell would have preferred he do. By giving to Harvard, Paulson can be certain that the institution will continue to thrive and be a steward of his funds 50 years from now. Did Paulson analyze the existing anti-poverty charities and find them too risky? I wouldn’t be shocked if he did.
Short of giving to the Bill and Melinda Gates Foundation1, I’m not sure how one gives huge sums of money to an anti-poverty charity at that scale while still minimizing one’s risks.
I’m not trying to argue that anti-poverty charities (or whatever Gladwell wants him to give to) are inherently risky. I actually have no idea. What I mean is that Paulson – by trade and by training as a hedge fund guy – has to be incredibly focused on risk management. You can’t succeed the way he has without applying the same eye for risk to one’s philanthropy. The one thing Harvard has over almost any other ‘charity’ is its image as a prudent low-risk investment.
Why would anyone like Paulson give to a ‘charity’ that already has a $36 billion endowment? Its a safe bet, that’s why.
4. The “smart guys” like Gladwell who represent conventional wisdom? Paulson does not give a fuck.
Just to expand for a moment on this fourth point, and to boil it down further with mathematical precision: Paulson gives precisely zero fucks what Malcolm Gladwell writes on Twitter.
Paulson’s “career trade” was made by understanding which way the entire mortgage bond market was positioned in 2008, and then he made the exact opposite bet, at extraordinary risk to himself and to his investors. In hindsight, he was a genius, but that move was incredibly difficult to make at the time, when every other short-seller of the mortgage bond market up until that point had gotten their ass handed to them.
Paulson’s smart enough to understand how the rest of the world thinks, but iconoclastic enough to lay that aside to determine what he alone thinks.
Most of us have a hard time going that strongly against the grain of public thought. Paulson’s entire career success is based on extreme contrarianism.
Lessons of Paulson’s gift
At the risk of trying to tie this all up with a neat bow, I think philanthropies can learn from the lessons of Paulson’s gift.
To appeal to a certain type of giver like Paulson, the point shouldn’t be to try to be the ‘worthiest’ cause in the universe, but rather to offer good value for the money. People who have made a lot of money in their lifetime tend to respond to value arguments – how will their gift have a bigger impact with you, rather than with someone else?
Further, are you the absolute best in your category? Forget neediness or worthiness. I suspect neediness is in fact a major turnoff for big donors. But excellence and being #1? Are you the Harvard of your category? I bet that’s very attractive to Paulson.
Next, are you a low risk? People who manage money for a living and who have a large fortune to steward want to see their money managed wisely, even after it’s given. Especially after it’s given.
Finally, does your donor give in order to be part of the in-crowd? Or to be an iconoclastic contrarian? We know by reputation that Paulson’s going to do whatever he thinks, not what the rest of the people think. That’s probably rare, but in the case of Harvard as a recipient, to their ultimate benefit.
I bet most people are social givers, eager to become or remain as a member of a social group, and philanthropic efforts to keep them appreciated as part of an inner circle probably matter a lot. Contrarians are rarer, but in Paulson’s case, can turn out quite nicely too.
[Fake full-disclosure/non-disclosure: I have given precisely zero dollars to my alma mater Harvard in the twenty years since I graduated from there, and I also give precisely zero fucks about Harvard’s philanthropic needs.]
If you haven’t heard of Shelby M.C. Davis – and relatively few people have because he’s a very private person – you’re missing the story of one of the world’s great investing families, as well as one of the world’s most generous philanthropists. He’s an all-timer.
The most important wealth-creating decision Davis Sr. ever made – mirrored later by his son Shelby M.C. Davis – was to found his own business.
Davis Sr. trained as a New York insurance regulator, making a respectable but limited salary from the State. At age thirty-eight he quit his job, borrowed $50,000 from his wife’s family, and set himself up in business as a stockbroker, with a seat on the New York Stock Exchange, specializing in insurance stocks.
Shelby M. C. Davis, his son, made an equally fateful decision in 1968 when he left his job as an analyst at the Bank of New York to join a few partners to found the mutual fund company which eventually became Davis Selected Advisors.
Now, founding a own company does not guarantee wealth, because most new businesses fail, and because lots of people end up earning less working for themselves than they did working for others.
On the other hand, equity ownership is the only way to create significant wealth. Every single large personal fortune – on the Forbes 400 list for example – results from business ownership, usually highly risky and undiversified to start. It might not have worked out – and undoubtedly even the Davises felt the risk of failure in the beginning – but owning their own businesses was the key first step.
Davis Sr. – sitting in his insurance-regulator seat – gained deep insight into the insurance business at a particularly propitious moment. In the post-World War II era, insurance companies traded at extraordinarily cheap valuations.
Davis also happened to combine two great insights. First, he understood value investing before the world had even heard of Warren Buffett. Davis was the president of value-investor Benjamin Graham’s stock analysts’ organization in 1947. Second, Davis dug deeply into the investment portfolios and business practices of insurance companies.
The result of Davis combining these two specialized insights closely resembled Warren Buffett’s path to wealth. Davis’ built his $50,000 initial investment stake into a personal fortune worth close to $900 million by the time he passed away in 1994. As the book reports, most of those gains came from purchasing insurance company shares, just as Buffett’s fortune grew from post-World War II insurance company ownership as well.
Shelby M.C. Davis, his son, invested in a wider variety of US and multinational companies, but his methods sprang from his father’s focus on specialized knowledge. Most importantly, Davis developed the art and science of deep dives into the quarterly reports of public companies as well as thorough independent research to discover attractive companies – classic value-investor practice.
Borrowing to the gills – leverage
Shelby Davis Sr. began his insurance brokerage with limited funds – $50,000 in 1948 – but took advantage of his ability to borrow money as a broker-dealer. Because of consumer protection laws, individuals who purchase stocks “on margin” through their broker can only borrow 50% of the value of their investment. A broker-dealer on the other hand, is allowed to borrow far more, limited mostly by what others are willing to lend them.
Davis Sr. purchased beaten-down insurance stocks for a living, and that alone might have made him a small fortune over his lifetime. Using borrowed funds as a broker-dealer, however, made him a huge fortune. The difference was that he magnified his returns by borrowing huge sums of money for decades.
In a sense, all fortunes require leverage. Sometimes this is achieved by borrowing huge sums of money as Davis did, or as many real-estate investors do. Sometimes the leverage is actually ‘operating leverage,’ as in the example of the top equity owner of a law firm who employs many junior attorneys to do the work for him while he reaps the benefits at the top of the pyramid.
More recently, social media firms like Facebook and Twitter achieve a different kind of leverage through massive network-effects. The programming and administration work required to support an online network of 10,000 people, for example, becomes much more interesting as a business proposition when extended to the currently estimated 1.3 billion users of Facebook. That’s another kind of leverage.
In any case, you need leverage to create huge wealth.
The $1,000 hot dog – tightwad behavior
Davis family lore tells of Shelby Davis, Sr. taking a walk with his grandson, Chris Davis, in Manhattan. Chris asked granddad whether he would buy him a $1 hot dog. Davis Sr. pounced on his grandson with an object lesson in thrift and compound interest.
Did grandson Chris realize that $1, invested wisely, would double in value in five years? Furthermore, did he realize that this $1, compounded over 50 years, when Chris would be his grandfather’s age, would become worth over $1,000?
Grandfather Davis asked: “Are you so hungry you need to eat a $1,000 hot dog?”
And that, ladies and gentlemen, is how wealthy people get, and stay, wealthy. It’s also an elegant lesson summarizing the key points of pretty much any book on building long-term wealth.
Let’s face it: Nobody builds a great fortune without a tremendous amount of luck. While it may be true that “the harder I work, the luckier I get,” many hard-working brilliant people who combine business ownership with specialized knowledge and leverage do not achieve the fortunes they seek.
In Davis Sr.’s case, two pieces of luck stand out.
First, he began making leveraged investments in insurance stocks just at the beginning of a period of extraordinary growth. While he had the discipline to never sell, his leveraged investment at the time of a profound equity market downturn could have led to a forced a sale. Luckily for him, his fortune did not suffer that fate.
Second, as author Rothchild describes, Davis Sr. took a pause from investing his fortune between 1968 and 1975, when he served as US ambassador to Switzerland. During that period a bear market in stocks crushed his then-personal fortune of $50 million down to $20 million.
While historical counter-factuals are difficult, Rothchild wonders what would have happened had Davis been more actively involved in investing during those years. His distance from the investing world in precisely those years may have been a piece of extraordinary financial luck.
Later, between 1975, when Davis Sr. returned to managing his money, and his death in 1994, his fortune soared with markets to nearly $900 million.
Giving it all away
Interestingly, Davis Sr. set an amazing precedent with his fortune. He was determined that his heirs should not be handed a large fortune to inherit, so he dedicated the vast bulk of his money to political causes he believed in.
His son, Shelby, who established his own mutual fund business independently of his father, earned his own fortune. Although Shelby Jr.’s sons have taken over management of that business, he has made it clear to them that they will not inherit his wealth either.
In fact, I met Shelby Davis because he is in the process of giving away his fortune, as fast as he can, to support higher education for students from all over the world.
Another reason I’m interested in this book, and the Davis family
Shelby M.C. Davis, the son, happens to be a personal hero of mine.
The Davis family mantra is “Learn, Earn, Return” – describing the 3 phases of a good life. After studying at Princeton and working for Bank of New York in his first thirty years of Learning, and then building a successful mutual fund company over the next 30 years of Earning, Shelby decided to Return the bulk of his wealth to a cause he believed in, just as his father had.
In the late 1990s he worried that American students were overly parochial in their understanding of the world beyond our borders. The future, he believes, belongs to people who can think and act internationally.
Davis discovered the United World College of The American West – a two-year International Baccalaureate high school with 220 students from 70+ countries, dedicated to leadership training, fostering an international social conscience, and bettering the human condition.
Over time, Davis realized that not just the US students, but also the students arriving from abroad, had the power to transform US higher education for the better by internationalizing US university campuses.
He invested – with little fanfare or even recognition – close to $100 million of his wealth in supporting this institution and its sister schools, the other 13 United World Colleges around the world.
 Clever users of the compound interest or discounted cash flow formula will easily calculate that grandfather Davis was assuming an approximate 15% annual compound return. An aggressive assumption for sure, but he managed to earn better than that during his investing career.