## Monday, November 24, 2008

### Lotteries, Millionaires, and a Sense of Scale about Money

Most of us dream of living the life of a millionaire. Many of us regularly buy lottery tickets, and more of us buy them when jackpots get larger than normal. However, few of us have a good sense of what is truly a large amount of money.

Imagine a young guy named Jack who is 25 years old and starting a new job. We look into a crystal ball and see that Jack will average an inflation-adjusted income of \$50,000 per year for the next 40 years. If you’ve never done the math, it can be surprising to realize that this amounts to two million of today’s dollars.

Now if Jack were to win \$1 million in a lottery, this would be only half as much as his total 40-year income. Even with investment returns, Jack would risk running out of money if he were to quit his job and spend \$50,000 per year. Even if he kept his job, he would risk running out of money if he spent \$100,000 per year.

So, unless Jack spends his winnings quite modestly, his good fortune will be temporary, and the money will be gone in a few years. We see this fate befall many lottery winners. Sadly, many end up spending themselves into huge debts after the money runs out. They simply didn’t understand that their big prize wasn’t so big compared to the length of a human lifetime.

For the average person to be able to quit working and live large, a lottery win of about \$5 million or more is needed. Even then caution is required. A sequence of poor choices, such as buying a money-losing dream bar or restaurant, can easily wipe out \$5 million in a few years.

The truth is that most millionaires accumulated their money while living frugally. Their financial habits are an important part of what has made them wealthy. Ironically, most real millionaires don’t live like millionaires.

The next time you encounter found money, whether it is a large sum or small, try figuring out how much it represents per day over 50 years of life. So, a \$50,000 inheritance divided by 50 is \$1000 per year, and divided by 365 is \$2.74 per day. Doing this might make you hesitate before wasting “found money.”

Some may find this “dollars per day” idea depressing, but I don’t see it that way. It comforts me to realize how long my expected lifetime will be.

1. I like using dollars per day for dividend income. It is neat to see how many dollars per day you can take in passively. A

nother interesting part of this is that is really shows you how much influence buying a \$4.50 drink from Starbucks can have. It deters me from starting any regular habit, like playing the lottery, which requires a small sum paid regularly.

2. MG: You're right about the high long-term cost of regular small sums. Many people just don't seem to think that these small amounts count. I recall a boy and his cousin playing baseball on the same team as my son. The father (and uncle) would pay about \$8 each game and practice for sports drinks at a corner store, but said he couldn't afford to get his son a new glove. By buying the drinks in bulk from a grocery store, he could have saved enough for a new glove in half a season. For some reason, many people always have \$10 to buy what they want, but can't come up with \$100 periodically.

3. Personally, I think the most prudent thing with lottery/inheritance is to invest it for income (bonds/equities) and only withdraw the distributions. \$1 million @ 4% spitting out \$40k/year isn't bad!

4. MDJ: That would be a great way to handle a windfall. Unfortunately, too many people blow the money with things like his and hers huge SUVs. Your example of pulling out \$40k per year makes it clear that the \$1 million only leads to a modest increase in spending if the money is going to last.

5. Your hypothetical Jack has to make \$50k a year to make \$2 million in income before he retires at 65. That's a lot of work to make \$2 million! This example assumes that's after tax, too. What would that be, \$80k pretax? Even if he manages to get paid that well, most of that money has to be spent on living expenses.

If that's not scary enough to get people investing, I don't know what is! I never really realized how hard it was to save a million dollars over the course of a lifetime of work. I guess that helps sell lottery tickets, since that \$80k salary is way above average, and still Jack is only going to make a total of \$2 million during his 40 year career.

If we take MDJ's 4% withdrawal rate (seems reasonable that it will be sustainable), Jack will require a \$625k portfolio at retirement to replace half his pre-retirement \$50k salary, and rely on government programs, pensions, and lower taxes to make up the other half.

Perhaps this would make a good future post. If I don't win the lottery, how long do I have to work, and how much do I have to save. Is it really just 10% of income (is that gross or net)? I suppose that is the ultimate question in personal finance.

I can just imagine your reaction when talking to the guy who "can't" afford the glove while sipping on over-priced, unnecessary sports drinks. Pack a water bottle, you jokers. :-)

6. Gene: Fortunately, compound interest works in favour of savers. So, if Jack manages to save, say, 10% of his income each year in stocks, he will have a healthy sum after 40 years.

I don't recall if I made any comment to the guy buying his son and nephew sports drinks at convenience store prices, but didn't have enough money for a new glove. I'm never sure what to say to make a useful impression.

7. I've learned not to say anything to attempt to enlighten people. It probably won't make a difference, and it will make them not like me. Nobody likes to hear criticism, especially from a stranger or mere acquaintance. This is one of Dale Carnegie's messages from "How to Win Friends and Influence People".

Best thing is just to enjoy the irony in private, and talk about it to friends... or blog about it.

8. I've often said that \$10 million is about the minimum needed to retire comfortably at a relatively young age.

A high-interest savings account return of 2-3% would pay \$200-\$300k per year in interest. Even taking taxes off that leaves you with plenty to lead a comfortable lifestyle without touching the prinicipal. If you continue to live frugally, then you'll just increase that seed money as you go.

The trick is to have enough that you don't need to spend it.

9. While I agree with the idea of small amounts adding up over the yers, I think you have to live a little too! At least, thats how i justify my little luxuries in life. I could get hit by a truck on my way to work today and all those pennies saved on a Tim Horton's coffee wouldn't matter one little bit.

Don't forget to live a little..you only get one shot at today..and then it's gone.

10. Astin: Even with a large sum like \$10 million you need to watch out for inflation. After 40 years, if inflation averages 4%, your \$10 million will only be worth about \$2.1 million in today's dollars. This cuts your income to \$42,000 to \$63,000 per year. So, if you get the money at a young age, you should consider investing the bulk of it in stocks. I tend to think of returns after inflation. Thinking this way, spending interest each year is eating into principal.

11. Anonymous: There are some people who live too frugally for whom the advice to "live a little" is a good idea. Unfortunately, there are far more people who use "live a little" to justify wasting money now at the expense of their futures.

12. It was pointed out somewhere in the blogsphere yesterday that 4% is a very odd inflationary number that is largely skewed by the 70's and 80's. Remove those decades and 2.3% is a more realistic percentage, which is around where we're at now.

On top of that, in 40 years I'll be long retired and worrying more about grandkids than my own kids. On top of that, if I live even remotely frugally, the income of a conservative investment will be reinvested in the principal, growing that amount as well. Toss in removal of debt, property ownership, etc., and while it might not outpace inflation and taxes combined, I'll hardly be in a bread line during my senior years.

Accumulation of wealth as an end unto itself is useless as far as I'm concerned. I'd be quite happy if I could spend the next 40 years not worrying about money instead of trying to accumulate net worth for some nebulous future where I'll be too old to enjoy it.

13. I think it's also worth considering how a couple years of negative returns (like in the current down market) could really hurt for those trying to live off their investments. Even if you've been really focused on income generating equities, there's always the chance of dividends being cut, thus forcing you to sell off principle to meet your living expenses.

While, admittedly, the severity of the current downturn is somewhat of an exception (or so I hope!), a stochastic simulation using the historical volatility of the market can help illuminate the ability of your asset base to provide a given income level for long periods of years. I'd certainly want to do an analysis like this if I was going to try and make a 30-year decision.