Tuesday, August 5, 2008

Common Problems with Sudden Wealth

David Hultstrom is a financial planner and wealth manager for whom I have a lot of respect. His most recent newsletter was very insightful and I thought others would be interested. His contact information is at the end if you'd like to subscribe.

Financial Foundations August 2008 Newsletter

This month I would like to talk about the psychology of "sudden wealth". While probably all of us have had pleasant daydreams about the possibility of suddenly coming into a large amount of money, in fact it can cause a great deal of stress. The source of sudden wealth doesn't necessarily have to be winning a lottery or receiving an unexpected inheritance. Many people face adjustment issues even from the sale of a business, or the rollover of a large 401(k) upon retirement. In those cases, even though net worth is unchanged, having the wealth more accessible and liquid somehow makes it seem more real. Following, in no particular order, are some comments that I think might be instructive:
1) People who are prudent with small amounts of money tend to be prudent with large amounts of money. People who are profligate before an unexpected inflow will be profligate with that inflow. Or, in other words, more income or wealth won't solve what is fundamentally a spending problem. This is undoubtedly the reason that studies have found between a third and half of lottery winners end up declaring bankruptcy.
2) Far too often people who come into sudden wealth seem to almost be trying to lose the money - and subconsciously, they might be. Most people become comfortable with a certain lifestyle, self-image, etc. When something happens to change that, they may try (perhaps subconsciously) to get back to where they were previously. This is the financial equivalent of the biological process of homeostasis.
3) People think that lump sums will go further than they actually will. Someone who has made $50,000 per year all their lives may see the $500,000 in their 401(k) at retirement as an incredible amount of money, when it really isn't. The most extreme example of this that I have seen is a very successful attorney who was approaching retirement. His main assets were about $1,000,000 in his 401(k) and the value of his partnership share which his partners would buy from him for about $500,000. I asked the couple how much they needed to live on in retirement and his wife replied, "We have a fairly modest lifestyle, if we continue to get what he makes now, we should be just fine." I asked the obvious follow up question, "What do you make now?" To which he responded: "About $500,000." I wanted to ask what they planned to live on in year four (but I didn't). I also didn't get them as clients. My guess is they went with an advisor who said they were in fine shape.
4) People sometimes try to "prove something" to someone such as a spouse or a parent (even if the parent is deceased). It is not uncommon for someone to lose a great deal of sudden wealth in investments or businesses trying to demonstrate how skilled they are at investing or business.
5) Sometimes people don't know what to do so they ignore the funds completely. I once did a financial plan for a schoolteacher who lived very frugally on her salary. Her primary concern was whether she could afford to buy a condo to live in rather than continuing to rent an apartment. Her father had left her some stocks when he died more than 20 years previously, and she not only didn't spend any of the money, she had never bought or sold anything in the account. It was untouched for more than 20 years and her net worth was just under $1,000,000.
6) The receipt of sudden wealth can also cause strains with existing friends and family members. Many wealthy people are treated differently and not uncommonly feel taken advantage of. Of course, new "friends" and "advisors" become prevalent as well.
So, what is the solution? The main thing is to proceed slowly. It is OK to leave the wealth in cash while becoming acclimated to the new situation. It may not be prudent to immediately move to a nicer area, a bigger house, etc. As a first step, paying off all debt, and committing to remain debt-free is probably prudent. In addition, thinking of the wealth as an income stream, rather than a lump sum may be helpful. As I covered in the July 2007 Financial Foundations, the sustainable withdrawal rate from a portfolio is about 4% per year. Thinking of a million dollar windfall as being able to pay off a $500,000 mortgage and then have $20,000 per year from the remaining portfolio to spend, may lead to vastly different decisions than thinking about what to do with a million dollars.
Note: Our clients are located around the country (and world), if you know someone we may be able to help, we would be happy to do so. While Financial Foundations is intended primarily for our clients, we are happy to expand our readership so feel free to pass this along. If you have received this from someone else in that manner and would prefer to get it directly from us each month, please let us know. Similarly, if for some reason you no longer wish to receive this (as unimaginable as that seems) simply let us know that as well.
Regards,
David E. Hultstrom
MBA, CFP, CFA, ChFC
Financial Architects, LLC
Financial Planning & Wealth Management
Address: 107 Weatherstone Drive, Suite 510
Woodstock, GA 30188
Phone: 770-517-8160
Fax: 770-517-8159
Toll Free: 888-Fin-Arch (888-346-2724)
E-mail: David@FinancialArchitectsLLC.com
Web Site: www.FinancialArchitectsLLC.com
Disclaimer: The information contained herein or as an attachment is intended solely for the individual or entity to whom it is addressed and may contain confidential and/or privileged material. All information is believed to be correct but accuracy cannot be guaranteed. Opinions expressed are subject to change without notice. All investments are subject to financial risk and there can be no guarantees that performance results will meet or exceed expectations. Any review, retransmission, dissemination, or acting in reliance on this information by persons or entities other than the intended recipient is prohibited. If you have received this transmittal in error, we apologize for the inconvenience. Please contact the sender and immediately delete and/or shred all copies. Thank you.

1 comment:

Blogger said...

eToro is the best forex trading platform for newbie and pro traders.