Tuesday, 11 June 2013

Watch out...winning the lottery or inheriting millions may not be the answer to your financial woes

I was having lunch with an old university friend recently who also became an investment banker after graduating.  He lives the 'banker lifestyle' and does not have a great deal in savings even though he is still in banking and is very well remunerated.  He mentioned that he plays the lottery every week and if he wins he will retire, buy the mansion and live a life of leisure for as long as possible.

Around the same time a reader sent me this excellent article on the danger coming into large sums of money and assuming that you are good at investing it when in fact you do not have the skill base required to make competent investments.

This caused me to start thinking about the problems that one faces when they come into a substantial sum of money.  This does not have to be from something like the lottery - those of us who do not play regularly (though 'dare to dream' occasionally) are never going to have a windfall like this.  However there are other windfalls which you can conceivably be fortunate enough to come across including

  • Receiving a small or large inheritance from a deceased relative
  • The company you work for gets sold and the stock you have been accumulating suddenly vests
  • You get made redundant and get paid out or take a redundancy package 
  • You win cash on a game show
However, if you are not careful, you can blow through this cash and have nothing to show for it

We have all seen the stories on television and heard about someone or the other who gets a whole lot of cash and then after 5 years has nothing to show for it.  It may even have happened to you - have you ever received even a small inheritance and then wondered where it all went just a short way down the track?

Why does this happen?

Although the ways in which this can happen are varied there are a few simple underlying causes which cause people to lose a windfall which should have helped them out financially.  These include:
  1. Treating themselves because 'you deserve it'
  2. Making bad or rash investments
  3. Taking advice from the wrong people

Most of us can see the problem with the first person however if you think about what you would do if you won a million dollars tomorrow I can guarantee you that some of it will be used to treat yourself.  If you buy a nice fancy house or car or even go on a big holiday with the money it can go very fast!

The second problem comes from people stepping outside their knowledge base.  They assume that because they have the money to invest in projects that were previously unavailable to them that they can only increase their funds.  Nothing can be further from the truth - unless your skill level has increased with the inflow of these funds - you should stick to things you know.

The third situation is possibly the most painful.  It involves those who know what they should be doing with the money but who trust the wrong people and who get ripped off or who do not understand what they are investing in and trust others to do the right thing for them.  This type of situation only validates my argument that you should only invest in what you know - trusting others is never the answer.

What should you do to avoid losing your windfall

As I have said above - sticking to what you know is the easiest way of making sure that nothing is going to surprise you but it's actually so much more simple than that.  We all have some level of financial competence and the easiest things to understand are actually the things you already know and should be doing.  

The real problem with these steps is that they are boring!  They do not offer you the chance to become a multi-millionaire in a year from a $1 million windfall but they do offer you the chance to improve your financial position over the long run.  Some things you could think about include:
  • Paying off your debts
    • Simple but debts often carry higher rates of interest than you could ever achieve by investing in it without the risk associated with the share market or other risk based investments
  • Put some aside for a rainy day
    • Put it into a high interest savings account which you know will never go bust
    • You will not get super high returns from the investment although if you do not touch it, it will always be there for a rainy day
  • Buy some index funds
    • Index funds are a low risk way of entering the share market - you get the return on the market (no under or over performance) for a very low fee
These are just some of the simple strategies you could do to protect your windfall.  You will notice that it is what I recommend you do even if you do not have a windfall and are just investing your savings and this is exactly the point - you do not want to do anything different!

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