Friday, 27 November 2009

"Make Hay While the Sun Shines": When Greed leads to Heavy Losses

An illustrative story.

Rick found out the hard way that greed leads to heavy losses, not gains.

At age 40, Rick had been in an unfortunate accident that would prevent him from ever working agin.  To compensate for his loss of future earnings, he was awarded a lump sum of approximately $4 million.  In 1996, Rick's attorney recommended that he seek out a financial planner to manage his money.  Rick's goals were to set up an investment portfolio that would provide him with current income of $8,000 per month, and an income that would keep pace with inflation over the balance of his lifetime.  Because he depended on income from his assets for his sole support, he wanted to be very careful with his money.

Lump sum: $4 million
Current income:  $8,000 per month

As the stock market advanced unabated, Rick started to listen to the siren's song of the easy money to be made.  He told his planners that he wanted to get more aggressive with his accounts.  The high returns and easy money that the markets were offering were just too good to pass up.  He acknowledged that he had told his planners that he needed to be conservative before, but now he felt that he should "make hay while the sun shines!"  In other words, he perceived that there was little risk involved in getting more aggressive.

Rick did not need to chase high returns because his asset base was sufficient to allow him to pursue a lower risk and return strategy.  Most important, he would always be okay so long as he kept his capital base intact to produce the income he required.  His planners counseled Rick to stick with his conservative income and growth plan because he could not earn back the money he might lose.  But by 1999, the siren song proved too much for him.  He abandoned his investment strategies and moved his entire portfolio into high-flying tech stocks just before the speculative bubble burst.

The ensuing "Tech Wreck" shattered Rick's financial security along with that of millions of other investors.  Greed had won again.  Rick's more aggressive investment strategy that had looked like a sure path to untold wealth became the wrecking ball that destroyed his financial security.  With losses that averaged in excess of 70 percent, Rick's capital base was decimated, and with it, the engine of his income production.

To add insult to injury, the income strategies Rick abandoned actually increased in value.  With the huge stock market declines, investors fled to the relative safety that income-producing investments provided.  Bond prices increased as did the prices of many high-yielding dividend-paying stocks.

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