Australia is on the verge of the biggest intergenerational wealth transfer in history. Over the next 30 years, around $2.4 trillion will be passed down by the parents of baby boomers and the boomers themselves, according to research by ING Direct.
Another report, by Bankwest, estimates that more than $400 billion in housing will change hands by 2025, with one in every 10 Australian homes to be given away.
In short, many ordinary Australians will inherit a pile of wealth and most won’t know how to invest and manage it, let alone deal with the emotional upheaval, because they’ve never had to before.
There are many high-profile examples of people who have become very rich, very quickly and blown it.
A recent one is 40-year old American rapper Curtis “50 Cent” Jackson who last year filed for bankruptcy. At the height of his career, Jackson amassed around $300 million, according to Forbes magazine, only to blow it all on reckless spending.
Human beings are wired to stuff up when it comes to money, according to behavioural finance, which combines behavioural science and conventional finance and economics to help explain why people are prone to making irrational financial decisions.
Irrational, emotional decision making
Behavioural finance studies show people don’t make smart decisions on the fly. They’re prone to irrational, emotional decision making, suffer from short-termism, and typically overestimate their financial abilities.
There are a number of academic studies which link financial literacy to wealth accumulation. One school of thought is that the more financially literate a person is, the wealthier they become. Others argue that wealthy people become more financially literate over time.
The problem with sudden wealth is there’s no time to gradually learn important lessons. Therefore, if a person’s financial behaviour and their beliefs around money management are flawed before they become wealthy they’ll continue clinging to those beliefs and become susceptible to making profound mistakes. Even worse, their focus tends to be on getting the money invested quickly and they become susceptible to listening to anyone with a believable story about how the money should be managed.
Knowing this, it’s crucial for Australians who are about to inherit substantial wealth to seek professional advice.
An adviser can help them make smart financial decisions which will ultimately see their wealth last.
Skill experience, objectivity and tools
Advisers have the skill, experience, objectivity and, importantly, the tools and technology to help clients avoid impulsive, destructive behaviour, keep a cool head and reign in spending which isn’t easy for people who have just inherited what to them might be unimaginable wealth.
A fundamental belief of behavioural finance is that a rules-based approach to investing will deliver better client outcomes because it ensures investors (and advisers) follow a clear set of well-thought out, predetermined guidelines and parameters designed to maximise the probability of a portfolio achieving its long-term objectives.
A managed discretionary account (MDA) is a solution which allows advisers to effectively incorporate key behavioural finance principles into portfolio construction and portfolio management.
Within an MDA structure, the managed account operator and the appointed portfolio manager (which could be the licensee or an external investment manager) collectively develop and provide an investment program that meets the client’s personal needs, preferences, objectives, beliefs and risk tolerance.
Advisers have the authority to make discretionary portfolio management decisions, provided they keep within the set mandate parameters. It removes the ability for investors (and advisers) to separate out the emotional attachment to their portfolio from investment return, hence creating a stronger, disciplined approach.
Managed accounts are set to become an increasingly important solution, as more and more people inherit large sums of money and become responsible for looking after it.
An intergenerational game changer
Wealth may not fundamentally change who a person is but it will likely magnify their personality traits. For example, people who are naturally generous will become even more so. Those who are tight with their money are likely to be extra conservative even though they can afford to spend more.
Unfortunately, any mistakes they make as a result of flawed thinking will also potentially be magnified.
While the average adviser may not look after many rappers, they do look after ordinary people who will soon be either benefactors or beneficiaries of significant wealth.
They’ll need help planning and overseeing the smooth and efficient transfer of wealth, putting appropriate safeguards and investment strategies in place, and managing that wealth.
Fortunately, in most cases, gaining an inheritance or windfall through the sale of a business or property won’t be a surprise. People generally know if they have a wealthy partner or family, which allows them to plan early, and possibly even with benefactors while they’re still alive.
Advisers can also facilitate that interaction.
Moran Howlett is a client of managedaccounts.com.au – a managed discretionary account operator and administrator.
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