22 April 2018

Investors Should Avoid Thinking in Lump Sum Terms

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Researchers from “The Illusion of Wealth and Its Reversal” simply stated that if you describe the same monetary value in two different ways, you’ll get two different (and opposite) reactions from the typical person. For example, for the average person retiring at age 68, there is no mathematical difference between receiving a single lump sum payment of $100,000 and a payment of $500 per month for life. Despite their financial equivalence, the average person would see the $100,000 as the more adequate of the two.

The research focuses on reframing this “Illusion of Wealth” from the point of view that people need to see numbers presented in a way they can better understand. Without a sophisticated financial calculator, it’s hard for the professional, let alone the average person, to know when a lump sum is adequate to fund retirement.

By looking at a monthly payout figure, people can more easily determine if it can cover their monthly expenses. This is why, when presented with a choice between larger number (e.g., receiving a lump sum of $1.6 million or $10,217 a month for the rest of your life – again, mathematically equivalent amounts), people tended to pick the monthly payment instead of the lump sum. Why did they switch their choice? The researchers believe it’s because people see the larger monthly sums as more likely to cover their monthly expense.

The trouble is that many expenses, like property taxes, insurance premiums, etc., are annual expenses, not monthly expenses. That means you don’t pay for the same amount of expenses every month. Unless you’re good at keeping track of your cash flow. It’s a whole lot easier to think in terms of the annual income needed to cover annual expenses. There’s an industry “rule” regarding this. It’s a little controversial, but it’s what really drives everything.

Click here to access the full article on Fiduciary News. 

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