Are you Wealthy or just Lucky?

In Investment Management, Luck is by far one of the most important factors. It is second only to the withdrawal rate for influencing the portfolio life. In the investment community, we generally ignore it. Many advisors feel uncomfortable conceding that the success of an investment plan has more to do with luck than their talent and good counsel. If you ignore the luck factor, the chances are you will suffer financially and this pain will continue for the rest of your life. On the other hand, if you accept it as large component of the outcome, then you will set yourself free to look for solutions.

One of the most elusive concepts in investment management is Luck. We strive to portray professional investing as a science. We talk about academic studies that conclude that “asset allocation accounts for over 90% of the variation in a portfolio’s investment return.” We show our clients the efficient frontier charts produced by reputable research organizations. Some of us run one hundred (years of) simulations, well knowing that there is no recorded stock index history beyond the last 115 years.

Yet after this entire charade, when I open a new account for a client, their parting words at the end of the meeting are invariably, “I hope I get lucky and I make some money!”

Photo by Sabine Peters on Unsplash

Most clients know about luck. It is us, advisers, who shun the concept of luck because it is incongruent with our training and sales material. We have been brainwashed too much with the so–called “scientific” nonsense in our financial curriculum.

Deep down, most of us know the importance of luck in investment. We avoid talking about it because we don’t know how to deal with it. After all, how can we gain the respect of our clients if we use terms like “luck” or “fingers-crossed” while giving them precise–looking forecasts thirty years into the unknown future?

Let’s look at how luck plays havoc with investment plans. I’ll expose some of the misconceptions in investment planning. I will define and quantify the contribution of luck.

First of all, what creates the luck factor? Any deviation from any straight line growth and inflation creates the luck factor. All secular and cyclical trends create these deviations.

The most important thing in a distribution portfolio is the sequence of returns. In this context, luck refers to the timing of the start of your investing relative to a secular trend. If you are lucky, the start of your investing coincides with the start of a secular bull market and you experience a favorable sequence of returns during the initial years of retirement.

The second important luck factor is inflation. In this context, luck refers to the general inflation level that you will experience during your retirement. If you are lucky, you’ll live in a low inflation environment during your retirement. This allows you to give yourself smaller pay increases to maintain your purchasing power.

The third important luck factor is reverse dollar cost averaging (RDCA). This is caused by cyclical trends. RDCA speeds up the depletion of your portfolio.

Let’s look at a retirement example: Bob, 65, is retiring this year with $1 million for his retirement invested in a balanced portfolio. His asset mix is 60% fixed income and 40% equity. His fixed income yields a net income of historical 6–month CD plus 1%. His equities perform the same as the DJIA. He needs to withdraw $60,000 annually, indexed to inflation.

Each of the starting portfolios had the same asset allocation, the same asset selection and the same management costs. The only variable was the timing of Bob’s retirement; if Bob were lucky enough to retire during the early years of any secular bull market, early 1920’s, early 1950’s or late 1970’s, then his portfolio would likely last him 30 years or more.

If Bob retired at any other time, 1900’s, 1910’s, 1930’s, most of 1940’s, late 1950’s, 1960’s or early 1970’s, then the portfolio life is about 17 years. It would not matter what the asset allocation was or how much he diversified internationally.

The transition from good luck to bad luck, or vice versa, is usually quick. For example: if Bob were to retire in 1973, his portfolio would have lasted only 17 years. If he were to retire in 1975, then his portfolio would last about 30 years.

The bottom line is, in 69% of time, Bob would have run out of money before age 90. While there is nothing we can do about luck, we can recognize and quantify its existence. This allows us to bypass the luck factor by looking at other income classes to create life– long income.