Sudden Wealth

Lottery winners and first time parents have something in common. If they manage their new responsibility wisely their lives may be enriched – but if they make mistakes - this can be a source of misery and regret for the rest of their lives.

Fortunately, for society as a whole, new parents usually do a better job of raising their firstborn child than lottery winners do in wisely managing their newfound wealth.

One of the most important, and most difficult, things for the suddenly wealthy individual is to clarify personal goals. Before becoming wealthy a common goal is to make enough to be able to educate the children, maintain one’s lifestyle and have a comfortable retirement. With sudden wealth the individual no longer has to get up in the morning to achieve these goals. But without goals and without a purpose to life there is a significant risk of spending too much time in idleness and seeking entertainment. Unfortunately there is a real danger for individuals when they lead a life with no purpose.

Sudden wealth, whether it comes from a lottery ticket, an inheritance, or the sale of a business - changes some things - but not everything. If we assume the individual now has $10 million or more, he or she no longer needs to worry about paying bills, can fly first class and can pay for the children’s education at the best schools - but 90% of one’s day will be unchanged. People will still spend most of their day doing routine things like getting dressed, eating meals, checking emails, watching TV, travelling, and working. And for people who have worked all their lives it is important that they continue working – not for the money - but for the activity. Individuals who have suddenly become wealthy should read the book called “Victory Lap Retirement” by Jonathan Chevreau and Mike Drak which explains why some form of work (paid or unpaid) is essential for a happy life.

When It Comes To Managing Investments

Those who are suddenly wealthy should understand that, just as you can be a good driver without knowing exactly how the car works, you can be a wise investor without knowing detailed investment strategies.

Good drivers need to obey the rules, use common sense, be patient, monitor the fuel gauge, have the car serviced by a reputable dealership, and watch the speedometer. But good drivers don’t need to know the difference between a camshaft and a crankshaft or a spark plug and a glow plug.

In a similar way, those who are suddenly wealthy, can manage money wisely without knowing how to analyze stock market valuations and without knowing the difference between a call option and a put option. Just as we have mechanics who understand and look after our car – we can have investment managers who understand and look after our money.

One of the challenges for suddenly wealthy investors is that the experts they interview, i.e., stock brokers, portfolio managers or investment managers, all seem to be nice people and they all seem knowledgeable, but they speak in terms that most people don’t understand. And the new investor doesn’t know the right questions to ask.

So Here Are The Questions That Inexperienced (But Wealthy) Investors Need To Ask:

1. Do you provide clients with a financial plan and could I see a sample financial plan?  You want a financial plan that shows the rate of return necessary to achieve your goals. This required rate of return will dictate the type of asset mix that is appropriate – given your goals and comfort level with volatility. You want to be in a ‘goals based’ portfolio where you take as much risk as necessary – but no more risk than necessary to earn the rate of return required to achieve your goals.
2. Can you explain the investment process that you follow?  It’s more important to follow a disciplined investment process –than it is to try to always find the best performing investments products. The process doesn’t have to be complicated but it has to be in writing and it has to explain when and why changes will be made to the portfolio. If the ‘expert’ doesn’t mention a ‘sell discipline’ or when the portfolio will be rebalanced, or can’t explain the process in a way that makes sense to you – they’re probably not following a disciplined investment process.
3. How do you suggest my portfolio should be diversified?  You want to be well diversified (with six to eight different investment mandates) so that all the different risks are addressed, e.g., stock market risk, inflation, currency, interest rates, income tax, and outliving your money. Do not, under any circumstances, believe that anyone can consistently predict where the market is going in the short term. With a disciplined investment process, there is no need to try to avoid the ups and downs of the stock market, because the ups and downs create an opportunity to rebalance and lock in profits.
4. Could I see a sample of your Investment Policy Statement (IPS)?  The IPS is one of the most important documents you’ll be asked to sign and you want to have an IPS that is in sufficient detail so that you can hold your advisors accountable. Investors should never sign on with an investment firm until they’ve seen the IPS and decide for themselves – is there enough information here for me to be able to hold this firm accountable for results. If you think it’s a good idea to have a blueprint before starting to build a house, or a recipe before baking a cake – you want an IPS before you let anyone manage your money. Be aware that if the IPS says that the allocation to Canadian equities can be between 0% and 100% this is too broad a range to be able to hold the manager accountable.
5. Could you remove the name and show me a quarterly performance report for a client that’s been with you for five years?  You need to receive a clear and easy to read quarterly performance report which shows the performance of your portfolio, as a percentage rate of return, and how this return compares to the appropriate benchmarks as set out in the IPS. Then you decide, has this client matched the appropriate benchmarks, (as set out in the sample IPS that you have reviewed) and will this report make it easy for me to see if the firm is achieving my target benchmarks? Without a clear performance report that shows performance against the proper benchmarks it’s just not possible to manage your money wisely.
6. How do you try to create income tax efficiency?  You need to be aware that income tax is our biggest expense and it is the ‘after tax’ rate of return that is most important. The ‘experts’ you interview should be able to explain what steps they recommend to minimize income tax.
7. Do you act as a fiduciary and can I hold you to the fiduciary standard of care?  You want to work with individuals who hold themselves to the fiduciary standard of care and are therefore required to put the client’s interest ahead of their own. (The fiduciary standard of care is much higher than the ‘suitability standard’ that most financial advisors adhere to).
8. Do you pick stocks and bonds yourself or do you use ‘best in class’ managers?  Maybe there is an advisor somewhere in the world who can pick Canadian stocks better than the best Canadian Investment manager, and Global stocks better than the best Global manager and Corporate bonds better than the best corporate bond manager – but I’ve never heard of such a manager, and if he or she exists, I don’t know why they would continue to take on clients. Investors should use ETFs or work with ‘best in class/ most appropriate’ managers. Understand that no firm has the best manager for every investment mandate. Investors should avoid financial advisors who want to pick the individual stocks necessary for a diversified portfolio.
9. Can you give me a written explanation of all fees I will be paying?  Investors need to understand all fees – and they need to see this in writing, but they should be aware that even a tiny fee is too much if no value is received. A reasonable fee is justified if value is received - and you measure ‘value received’ by comparing actual results to an ETF benchmark which has the same level of risk.
10. Who is your custodian?  Investors should never issue a cheque in the name of the advisor or investment manager. Cheques should only be issued to a reputable and independent custodian. This is how you avoid the ‘Bernie Madoff’ problem.
11. How do you avoid the conflict of interest that exists when investment managers pass judgement on their own stock picking performance?  It’s not possible for an underperforming investment manager to avoid a conflict of interest when explaining why he or she shouldn’t be fired. You want to work with a firm that is structured to minimize conflicts of interest. If a potential manager buys and sells stocks and reports on his own performance – ask under what circumstances will he suggest that he should be fired.

Avoid These Common Mistakes:

1. Believing that you have to make investment decisions right away.  It’s okay to put the money in a savings account and give yourself a year to make your decision.
2. Believing that a very experienced investment manager is smart enough to consistently predict where the stock market is going to go in the short term.  If any individual could consistently do this – he or she would be too rich to take on new clients.
3. Don’t be over diversified.  Having six or eight Canadian equity managers is over diversification because all the managers will be impacted in roughly the same way when the Canadian market is going up or down. Over diversification means money is wasted on management fees and it creates an investment portfolio that is too complicated to manage or to rebalance when necessary.
4. Not asking to see a performance report before becoming a client.
5. Having too complicated a portfolio.  Investors need to keep it simple because a complicated portfolio is too hard to manage, it can’t be properly rebalanced and is usually an indication that no investment process is being followed.

It is worth noting that some financial firms help wealthy clients by putting together a ‘stewardship council’ where professionals including life coaches, legal advisors, estate planners and accountants gather on a regular basis to ensure that all aspects of the client’s well-being are addressed. If the advisory firm offers such a service - suddenly wealthy individuals should use the service, at least until the management of the wealth no longer seems to be a chore.

Finally, if the financial plan shows that there is more than enough money to achieve all financial goals – you should have some fun with the money and give some of it to family or charity – because you don’t take anything with you when you die.

Warren MacKenzie, CPA, CA is a Principal and Stewardship Counsellor with HighView Financial Group. HighView is an experienced boutique investment counselling firm, dedicated to developing sustainable wealth solutions for Canadian families and foundations. Email: wmackenzie@highviewfin.com Tel: 416.640.0550