Lottery Winners Go Bankrupt Just as Often as Non-Lottery Winners

This article discusses bankruptcy.  Before I start, let me say that I wholeheartedly believe that bankruptcy is sometimes the best option.  In fact, people often wait too long to declare bankruptcy, causing their ultimate net worth to decline even more and postponing the recovery period.  I’ve even gone so far as to recommend bankruptcy to members of my own family after looking over their balance sheets and income statement.  My comments here are in no way an indictment of the bankruptcy process.  If you find yourself there, no matter how you got into that position, the important thing is figuring out where to go in the future.  Forgive yourself, move on and start rebuilding.  We all make mistakes.  Our lives our the sum culmination of the decisions we’ve made in the past.  Learn from what you did wrong and start making better decisions.  There is no point wallowing in sorrow or being embarrassed because both are distractions from what you should be doing, which is re-establishing your household finances and accumulating wealth.

Giving People Money Doesn’t Solve Their Problems

A lot of times, people convince themselves that if “they just had a little more money” they wouldn’t be in the financial dire straits they are.  Their bills would be paid.  They wouldn’t have financial stress.  The problem is, everyone else with any sense in their life is likely thinking, “Yeah, you’ll be right back in this situation in a few years” but no one wants to say it aloud.

You see it all the time with talented high school and college students who go into professional sports.  Last year, I wrote an article at Investing for Beginners talking about a finding that a staggering 78% of NFL players were bankrupt or broke within 2 years after retiring!  At least the NBA is a bit better (but not much) – according to The Toronto Star, 60% of NBA players are bankrupt or broke within 5 years of retiring.  I want you to think about those numbers; really reflect on them and what they mean in terms of human experience.  They are so important I am going to repeat them.  Within two years of retiring, 78 out of 100 players in the NFL are broke.  Within five years of retiring, 60 out of 100 players in the NBA are broke.

Laura Rowley has a great article over at Yahoo Finance that illustrates a point that has been well-known in financial circles for years: Lottery winners go bankrupt just as often as non-lottery winners because they don’t know how to manage money. Now, it seems, there is empirical evidence to backup this claim.

According to Rowley’s article, Mark Hoekstra, assistant economics professor at the University of Pittsburgh, co-authored the paper with Kentucky’s Scott Hankins and Vanderbilt’s Paige Marta Skiba.  Their methodology:

The researchers identified 35,000 people who won between $600 and $150,000 in Florida’s Fantasy 5 lottery game from April 1993 through November 2002. (They eliminated the 153 people who won more than $150,000). They cross-referenced that list with people who filed Chapter 7 or Chapter 13 petitions in Florida five years prior to winning the lottery and five years afterward. Then they compared people who received $50,000 to $150,000 to those who won less than $10,000.

The findings?

They found 1,943 winners — or 5.5 percent — declared bankruptcy within five years of taking home the jackpot. While the bigger winners were 50 percent less likely than small winners to file for bankruptcy within 24 months, they were more likely to file for bankruptcy three to five years after winning. The net result is that within five years, large winners were just as likely to file for bankruptcy as small winners.

In the case of lottery winners, bankruptcy was merely postponed not avoided.  Why?  That is easy.  Making money, allocating capital, managing risk, efficient tax planning, intelligent portfolio construction … all of these things are skills, just like playing the piano or learning a new language.  Being handed a lot of money doesn’t come with the related skills that would be present if the person were first-generation wealthy or had grown up in a wealthy household and absorbed the lessons that come with handling large sums.  In most cases, the lottery winners probably increased their fixed cost basis, thinking of their wealth as a lump sum to be spent rather than as an engine that could produce private income.

The Lottery Winners Had Almost No Assets on Their Balance Sheets

The articles goes on to explain that most of the lottery winners treated their winnings as “found money” and didn’t use any of it to better their financial lives!  I can’t even process that type of thinking.

Moreover, when people who won $25,000 to $150,000 did file for bankruptcy, their net assets were just $8,000 higher than those who had won less than $1,500. Bottom line: The median big winner took home $65,000 in cash. That would be enough, on average, to pay off all unsecured debt or to boost the equity in new or existing assets. Instead, the big jackpots simply evaporated.

“The fact that winning a large sum of money only postponed bankruptcy rather than prevented it didn’t surprise me too much,” says Hoekstra. “But I was struck by the fact that when the recipients of large sums did file for bankruptcy, they didn’t have much of anything to show for the winnings they had received. It didn’t go toward a house, paying down debts or buying assets that were worth something a few years later. We couldn’t find any evidence that five years earlier, these people had received what would be, for many people, a life-changing amount of money.”

What I Would Do with Lottery Winnings

You know I believe that you shouldn’t comment or criticize unless you are willing to offer a solution.  How would I act in this situation? If I were to win the average prize – $65,000 take home cash – what would I do with it?

Most likely, I’d go buy some rental property and demand a 10% annualized return.  The investment property itself would take care of inflation adjustments so my pre-tax passive income would increase by $6,500 per year.  That is roughly $541.67 per month.

In other words, I wouldn’t think of myself as having won $65,000.  I’d think of myself as having won an additional $541.67 in pre-tax passive income each month.  As long as I never touched or borrowed against the principal, I could spend it and not worry about going bankrupt.  That is enough to make a decent car payment or shop at Brooks Brothers, buying a new custom sport coat each month, especially if you waited for the clearance sales.  Of course, if I were in the situation of a lot of these lottery winners and didn’t have a core economic engine capable of supporting the standard of living I wanted, I wouldn’t be doing any of that.  Rather, I’d be funneling the income stream back into acquiring more productive assets, producing ever-increasing sums of passive income.

In other words, if you spend the $65,000 you aren’t just spending $65,000!  You are really spending all of the passive money it could have earned for you and your family from now until doomsday. If you live another 40 years, you would not only still have your $65,000 but you would have been able to spend $260,000 in dividends, interest and rents over the years.  Again, it is a case of having your cake and eating it, too, if you are just a tiny bit patient.

The Moral of the Story: It Is About Behavior

The moral of the story is that giving someone more money almost never solves their problem, which is behavior.  In some cases, giving them money can make the situation worse.  Financial independence is a by-product of specific types of behaviors such as spending less than you earn, prioritizing the purchase of things that hold their value or appreciate over time, putting excess savings into investments so they generate cash, avoiding debt, etc.

If someone pays out more than they take in from a paycheck or investments, they will go broke at some point.  This isn’t rocket science.  It is a universal truth of mathematics.

Rowley wisely goes on to point out that these findings have implications for government welfare and assistance programs:

The study has policy implications for governments deciding how to help heavily indebted people who are struggling during economic downturns, Hoekstra says. It appears the simplest solution — giving them cash — doesn’t enhance longer-term financial stability, and only postpones, rather than avoids, bankruptcy. The lottery findings are consistent with a 2007 research paper that showed consumers initially used their 2001 federal rebate checks to reduce debt, but eventually debt returned to its pre-rebate level.

“Our research suggests that perhaps there is something more systematic about the types of people who get themselves into financial trouble — and the appropriate policy prescription for helping them out is going to be considerably more complex than giving them additional resources,” says Hoekstra.

In other words, it is the way the people behave that gets them into trouble not the total income they have.

Update: I made this available on 05/18/2019 as part of a project involving the release of selected posts from the private archives.  I cleaned up the page, slightly reworded certain passages to read better, and adapted the format to the new site template, including using higher resolution images.