How Do You Know When You Have Enough?

(MoneyWatch)  (Note: This is part one of a series regarding how your financial makeup should determine your investments. For other posts in the series, see the link at the bottom of the item.)

The strategy to get rich (work hard and take big risks, typically by owning a business) is entirely different than the strategy to stay rich (minimize and diversify your risks, and don't spend too much). Consider the following story.

In early 2002, I met with a 71-year-old couple that had $3 million, down from $13 million from just three years earlier. Their portfolio had been almost entirely concentrated in technology stocks. I asked them if it would have made any meaningful difference in their lives if their portfolio had doubled to $26 million instead. The response was a definitive no. On the other hand, the experience of watching the $13 million shrink to $3 million was very painful. I then asked them why they had taken the risk knowing that the potential benefit was not worth much but a negative outcome would be very painful. The wife turned to the husband and punched him, exclaiming, "I told you so."

The reason they took such risk is because they failed to consider their marginal utility of wealth: how much any potential incremental wealth is worth relative to the risk taken. While more money is better than less, many of the people I meet with in my role at Buckingham Asset Management achieve a comfortable lifestyle at some point. At that point, taking incremental risk to achieve a higher net worth should no longer be acceptable, because the potential damage of a negative outcome far exceeds the benefit that would be gained from any incremental wealth.

Failing to consider the need to take risk is a common mistake, especially for those who became wealthy by taking large risks. When I encounter this, I remind people of the ancient Chinese proverb from the Tao Te Ching: "To know you have enough is to be rich."

Follow the series:

• Part one: How Do You Know When You Have Enough?
• Part two: Are You Taking Too Much Risk?
• Part three: Are the Rewards Worth the Risks?