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Why do some rich people go bankrupt?

Why does something like this happen? Each of these examples are unique, but much of these are due to behavioural issues. We will try and cover the most common mistakes and steps to avoid any such catastrophic collapse in wealth.

Over the past few months, we have seen several extremely successful businessmen in India go bankrupt, or at least lose a significant portion of their wealth. There are several known examples of movies stars and sports celebrities going bankrupt across the world.

These kind of stories are not limited to only famous people. Several common people, like you and us, have seen a significant portion of their wealth wither away and thereby taking away their dream retired life. This is probably one of the most painful experiences to go through, especially after working hard all life long, and then see your wealth disappear.

Why does something like this happen? Each of these examples are unique, but much of these are due to behavioural issues. We will try and cover the most common mistakes and steps to avoid any such catastrophic collapse in wealth.

At some stage, consider setting aside a pool of liquid assets in a special vehicle (say a Trust), which cannot be touched and it should provide for your regular expenses. Such safety nets help you protect yourself and your family from any unforeseen liabilities.

1. Don’t buy things on a whim

One of the most common reasons for bankruptcy is the habit of making whimsical financial decisions. It can be an asset or an over aggressive business plan. Do take time when deciding. Discuss with your family or some of your ‘wise’ friends before committing to any large financial commitment.

2. Don't Over-leverage

One of the most common reasons for bankruptcies is through borrowing beyond what is normal or required. This can be for personal reasons or for business reasons. Once you have a certain amount of wealth, avoid borrowing completely. Even if it is for your business, it is important to keep overall borrowing to bare minimum levels. Borrowing, at best, should be limited to plan for your taxes better or for cash flow planning.

3. Understand what you can spend

You can at best spend 4% of your financial wealth in any year. If you are dipping any more than that, then you are clearly over spending. This will ensure your capital is protected and will grow in line with inflation.

4. Limit illiquid investments

A common problem with investments, for many rich folks, is excessive exposure to illiquid investments. This can be an exposure to a private company or a property which is difficult to sell. Sometimes it even has title risk.  Illiquid investments should be kept to minimal levels.

5. Set aside your ‘safety’ bucket

At some stage, consider setting aside a pool of liquid assets in a special vehicle (say a Trust), which cannot be touched and it should provide for your regular expenses. Such safety nets help you protect yourself and your family from any unforeseen liabilities.

6. Get Health insurance

With increasing cost of medical expenses, it would be wise to take a substantial medical insurance policy. At times, such expenses can drain your financial savings significantly.

7. Plan your portfolio well

  • Focus on inflation beating assets, but not excessive risk. Listed equity investing, over time, should be one of the important component of your portfolio.
  • Avoid leverage in your portfolio.
  • Illiquid assets should be less than 25% of your overall portfolio.
  • Too much risk or too little risk (bank deposits) are both not optimal.
  • Have a reasonable mix of debt, equity, and property in your portfolio based on your overall comfort level.
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