Here’s a fun fact of personal finance: a 2010 paper published by Vanderbilt University, the University of Kentucky and the University of Pittsburgh asserts that winning a substantial amount of money from the lottery actually increases your chances of going bankrupt within 5 years. The paper is available here.
That seems counter-intuitive, doesn’t it? A person gets a tremendous windfall with comparatively little effort and somehow manages to go broke? Plenty of evidence, from studies like this and other anecdotes, suggests that the effort in earning your dollars seems to have a great impact on its emotional significance and – more pointedly – how carefully the money is spent. Lottery winners – unaccustomed to higher taxes, appropriate spending levels and other hazards with newfound wealth – can easily overlook the dangers and get right to the fun part. Conversely, attaching effort to an item (and by extension, your money) can increase its perceived value; some clever researchers at Harvard Business School have coined this phenomenon as “The IKEA Effect.”
Why are we talking about winning the lottery right now? Is there any relevant lesson to be learned from the money gained without effort?
Let us consider that, over the past month, several market benchmarks have hit all time highs. For instance, the S&P 500 broke through the 1600 trading level for the first time in history and is currently trading around 1645. The double-digit year-to-date returns in equity markets have been greater and more rapid than the major investment banks dared to predict.
In the face of this windfall, it is easy to complacently expect more of the same. Of course, nobody knows exactly when, or if, the market sentiment will change. Nobody knows how much froth will be taken out of the market if short term investors get spooked by a volatile macro event, like an international conflict, a terrorist-driven or natural disaster, or an escalation of an established financial crisis. We will be paying close attention to aggregate investor behavior – measured by consumer sentiment and fund flows – to look for the possibility of short-term fair-weather investors who have seen the high returns of the market and believed that the storms are over, never to return again. Of course, our views presume that both up markets and down markets are absolutely inevitable. We continue to emphasize the long term investment goals of our clients rather than trying, with futility, to predict the short term directions of the market.