What Role Does Luck Play in Your Finances?
What Role Does Luck Play in Your Finances?
I’m sorry to say, but a lot. As much as financial advisors like to portray an aura of certainty to their work, a lot of your financial future is riding on luck. From how the economy performs at important milestones in your life to your health and longevity, there are countless variables that we have no control over or can even anticipate happening (a la the COVID-19 pandemic). Therefore, financial plans are built on many assumptions that simply will not happen. This sucks but it’s reality.
Here is an example of just one way that luck shows up in your financial life. Take the following two scenarios. In both of these scenarios, a new retiree starts with a $1 million investment portfolio to cover $50,000 in living expenses. In both scenarios, the average rate of return is 6%, which anyone would consider a decent return for a balanced portfolio. The only difference is the sequence of how those returns came to be. Scenario B has the same order of returns as Scenario A but backwards.
BTW, having negative returns at the same time you start taking distributions is called sequence-of-return risk. Also, if you think that a -22% return is not possible for a diversified portfolio, sorry to burst your bubble because it happened in 2008.
Well hot diggity dog, the retiree living through Scenario A will have less than half the amount at the end of 15 years than the retiree living through Scenario B. Did the retiree in B do something better than the retiree in A to cause this? Well, unless you call throwing a dart at a calendar to see when you’ll retire an investment strategy, no. It was all luck. She was just plain lucky that the returns went in her favor while the retiree in A was not so lucky. Unfair? Yes. Does the market care? No.
However, just because there is a big luck component to your money life doesn’t mean that financial planning is not important. In fact, it is because of all this uncertainty that planning is utterly important. We have to plan that returns won’t necessarily work out as we hoped. This is where the word “plan” used as a verb instead of noun becomes crucial. A good plan is not a one-and-done deal. It is responsive to life, the markets, pandemics and all that other crazy shit out there. It will allow the advisor and the client to pivot in the face of the new reality. For example, in Scenario A above, the financial planner could have told the client in year two that a withdrawal rate of 6.75% ($50,000/$741,000) is quite high for a 30+ year retirement plan and that they’ll have to adapt. They could have then adjusted the withdrawals downward for a bit and used the carefully planned for emergency savings to make up for the shortfall. The result of Scenario A with a pivot:
Almost $200k more in year 15 after a pivot than without. Will this make up for all their bad luck? Of course not, but it does give the retiree a lot more breathing room. Further, this is just one tool out of many that the financial planner can help you think through. For example, returning to work part time on a passion project for just four years so that withdrawals are $20k in years two through five would result in an ending balance of $850,000 given the same return assumptions. Win and win.
Keep in mind that market returns are just one variable out of thousands that have a luck component to them. Although there are some things that we can’t do anything about regarding your future finances, there are plenty that we can control. The sooner you can incorporate uncertainty into your plan, the more time you’ll have to build pivot options to respond. Lucky you that you found me.
Interested in taking the luck (to the extent it’s possible) out of your financial life planning? Click below to schedule a free intro call today.
