By Jeffrey Stoffer, a financial advisor on NerdWallet’s Ask an Advisor.
“Will I run out of money before I die?” I wish I could say there was a simple “yes” or “no” answer to that question. The answer is more complex — it’s the result of many factors including probability, luck and skill.
“Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets,” by Nassim Nicholas Taleb highlights the common ways the human mind interferes with clear decision-making. He asserts that luck plays a larger role in our lives than we realize. We tend not to see it for a number of reasons. We look for patterns even where there may be none, and we seek easy black-and-white explanations. We may wrongly assume causal relationships between things that are not related. A corollary is to mistake luck for skill.
In looking for patterns and explanations, it is easy to get it wrong in situations involving investments and the markets. For example, just this morning I saw the headline, “Stocks drop, gold and yen rise on Ukraine violence.” These items may only be related by coincidence, yet the implication is that the investment moves resulted from the violence in Ukraine.
Is that person smart or lucky?
With a visit to the dentist, it’s relatively easy to recognize a particular level of skill in what he does. But how many times do we give credence to someone being held up as skilled because he or she correctly called the real estate bubble or the rise in gold, when in fact that person happened to get it right purely by chance?
When it comes to investing and understanding moves in the markets, so many factors are in play that Taleb suggests that people do get it right, often by luck. If we mistake this luck for skill, we are more apt to take a person’s advice, since we believe he is indeed “smart.” How can we learn to tell the difference?
Looking for a simple answer
As humans we like simple explanations and black-and-white answers. Many variables are involved in attempting to answer: “Will I run out of money before I die?” In addition, randomness or luck will also play a part. A better question might be, “What is the probability — either running out of money or having enough?”
While there can be no absolute certainty, our goal is to maximize our chances of success. The only way to do that is to take actions. Doing nothing leaves everything purely to chance. A financial plan can’t guarantee success, but with a little luck and skill, the answer to the question, “Will having a financial plan keep me from running out of money?” is more likely to be “yes!”