Financial Planning for a Windfall in Wealth: Lotteries, Stock Options, Inheritances and Other Surprises

So I've lived in this community for, gosh, nearly three decades.

In that time, as a CPA serving thousands of business owners and affluent taxpayers, I've seen a pattern repeat itself time and time again when someone receives a big financial windfall. A giant bump in income from Microsoft or Google or Amazon stock options, say. Or a massive influx of money from the profitable sale of a business or family real estate, for example.

The Pattern to Financial Windfalls

Here's the pattern. Unfortunately, and quite in contrast to what one would hope, windfall wealth (including inheritances, lotteries, stock option grants, and large signing bonuses) seems to trigger four, really common financial mistakes:

Mistake #1: The Top Gear Car Effect

I don't watch the British Broadcasting Corporation's car show “Top Gear” anymore. But I used to watch the show a lot. And if you've even seen the show (or its German or American knock-off), you know each episode is mostly about the hosts driving expensive super-cars: high-end Porsches, Ferraris, Lamborghinis, Rolls Royces, Bentleys, and bunch of other outrageously costly cars that most of us don't even know about. (Or at least don't know about until we start watching the show and then wonder, "hey, maybe I do need a car that goes 200 mph.")

This maybe doesn't seem connected to the subject of receiving a windfall, but I will tell you that when someone suddenly finds themselves managing, say, a giant bump in their annual income or net worth, the first mistake a person often makes is letting the wealth and the euphoria that accompany the wealth trigger a wave of hyper-spending on items like expensive cars, second homes and other extravagances.

Accordingly, if you do find yourself with a financial windfall, work hard to contain and restrain your spending. Probably, as boring as this sounds, you should not spend the windfall. Rather, you should save the entire windfall (or whatever is left over after taxes) and then spend the investment income you earn on the windfall. (More on this subject in a few paragraphs...)

Mistake #2: I Am Invincible Syndrome

Over-spending isn't the only mistake people make. Mistake #2 is what one might call the "I Am Invincible" syndrome. Huge windfalls often flow out of really significant business or investment success. And that's really neat. (Congratulations, by the way, if you've had such a success.) But that success has a downside. That success can cause one to ratchet up one's self-confidence in business and investment matters to point of over-confidence and sometimes, and dare I say it, delusion.

Perhaps this is a good point as any to share a personal anecdote. The year I (foolishly) decided to start a traditional book publishing company was the same year I reached the high point in my book royalty earnings and was profiled in the Wall Street Journal. Ugh.

There's a weird contradiction here, in a sense. At the point when you (or I) feel smartest and most confident about our business or investment skills, we're probably most vulnerable to making some sort of silly financial mistake. Investing in some asset (a hedge fund?) we have no business even looking at... Making a big "angel investor" commitment to some family member's new venture... Deciding to go ahead start new, high-risk venture (like a book publishing company) using a large chunk of some windfall.

Here's my suggestion based on these observations. I actually think "post-windfall" that you want nothing other than boring, hands-free investment stuff. Like a half dozen really cheap index funds. Or some nondescript, slightly boring apartment buildings. In short, you and I want the stuff that your least financially sophisticated friend or family member would do okay in.

Mistake #3: Overwhelming Complexity

Accountants and lawyers, in a way, make their money when clients' financial and business affairs get complicated. And oddly, lots of people sort of like financial complexity. Perhaps we all tend to view the financial complexity as a sort of badge of sophistication. Personal corporations, asset protection trusts, investment LLCs--these items all seem like the sort of thing one should be doing with a windfall, right?

But you know what? If tomorrow someone gave me a $100,000,000, I really think the very smartest thing to do would be to buy a small handful of low cost mutual funds (probably the institutional class shares Vanguard offers). I would not (assuming I still had my senses) make the mistake of massively ratcheting up my family's financial complexity. The only change would be that the numbers on the year-end statements would be a quantum jump larger.

Mistake #3, then, is the mistake of letting a windfall ratchet up the financial and business and legal complexity of your personal and your family's finances. Try to avoid this...

Mistake #4: Financial Host

Finally, a few awkward words about a fourth windfall-related mistake many people fall into--and for all the very best reasons: Allowing oneself to become the financial host to family, friends, charities, and financial advisors who become, essentially, financial parasites.

Listen, I feel bad saying this. Most of the people who fall into this category are good people. The family members and friends you probably care about and love. And the charities that probably work on really important stuff. And, shoot, financial advisors (including accountants) that really do need to get to paid for their time and expertise.

But, seriously, once you kick back some extra money to your kids or parents (graduate school for a son, a nice home for mom), jack giving to a local charity, and start paying your financial advisor an extra $20,000 or $30,000 a year, hey, you've probably burned off way more of your money than you even realize.

For the first three mistakes, I had little suggestions about how to sidestep the mistake. I'm not going to do that, probably can't do that here. Who you choose to share your good fortune with is really too personal for general advice. But let me say two things:

  1. The people asking for your help often have no idea about how fast the money goes after paying, for example, forty percent in income taxes, forking over investment management, legal and accounting fees, and then paying for the increased lifestyle costs that often go with a windfall.
  2. Unless you avoid the windfall mistakes described here, I think your financial good fortune will be quite transitory. I respectfully urge you to keep that in mind if you make any long-term commitments to people or charities.

Avoiding the Windfall Wealth Mistakes

To avoid the common windfall wealth mistakes, my general suggestion is that you invest rather than spend the windfall...and then that you spend (in whatever way you want) the investment income the windfall wealth provides.

This tactic should be pretty easy to employ. Perhaps ironically, the investing is actually pretty simple. Without sounding too simplistic, one wants to have a very equity-heavy (stocks heavy) portfolio in order to maintain wealth over the long term. One needs to broadly diversify to minimize risks (especially catastrophic risks). And one needs to really watch the investment costs (such as amounts paid to outside advisors).

Investment advisors suggest a variety of "asset allocation" formulas for achieving these objectives. And in any particular market, one guru's approach will do a little bit better while another guru's approach will do a little worse. But if you pick a good, reasonable formula, that is really a pretty optimal approach. I especially recommend entrepreneurs keep their investments simple. Businesses create more than enough complexity.

The approach I personally use and almost automatically recommend follows the formula promoted by David Swensen, the former Yale University Endowment Fund manager. Swensen, a true world-class investor, suggests that people allocate their investments using low-cost index funds with the following breakdown:

U.S. stock (such Vanguard Total Stock Market Index Fund): 30%
Developed markets (such as Vanguard Developed Markets): 15
REIT (such as Vanguard Real Estate Investment Trust): 15
Intermediate Treasuries (such as Vanguard Intermediate Treasury): 15
Inflation Protected Treasuries (such as Vanguard Inflation Protected): 15
Emerging markets (such as Vanguard Emerging Markets): 10

The above formula's equity emphasis should provide good long-term performance. It reduces risk through diversification. Finally, the formula results in very low costs. With a $2,000,000 investment account, for example, your actual annual costs might be $2,000 to $4,000. (Some investment advisors and programs will charge you as much as $40,000 a year for a program that's arguably inferior.)

A couple of final comments:

First, all you need to do to put this program into effect is send a handful of checks to a mutual fund company (like Vanguard) each month. Easy.

Second, periodically you would want to have your actual holdings adjusted so the percentage allocations match the program.

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