What Does Luck Have To Do With It?
By: J SCOTT
Today's topic might be a little bit controversial to some. But that's okay -- I've never been one to shy away from putting out information, even if it's a little controversial.
I want to talk about the intersection of wealth and luck. What role does luck play when it comes to people getting wealthy, and the wealthy maintaining and increasing their wealth?
I've spoken with people on both sides of this camp. From those who believe that luck is the only factor in wealth creation (if you're not born into it or are lucky enough to be in the right place at the right time, you'll never have it) to those who believe that luck is completely inconsequential in the equation, and all that matters is preparedness, hard work, and a modicum of risk tolerance (basically, we all have equal opportunity and the only luck is the luck you make yourself).
Like most people I speak with, I fall somewhere in the middle. While you'll never dissuade me from my belief that good decision making and hard work is a significant part of professional and financial success, I don't have to look any further than my own life to recognize that luck plays a role as well.
But, while I have many personal opinions on the topic (and I'm sure everyone reading this does as well), as a former and long time engineer (and one time physics major), I enjoy looking at things from a more scientific perspective whenever possible.
Where Physics Meets Economics
It's turns out that some of the most interesting quantitative research around wealth inequality comes from a little known field of study known as econophysics. (Yes, physicists building theories around economics.)
Econophysics is essentially the application of physical models of the world as applied to economics problems. While this might seem like a strange crossover, consider that an economy -- to a large degree -- is simply the outcomes of large numbers of interactions between people who exchange currency/goods/services. And certain branches of physics specialize in analyzing the outcomes of large numbers of interactions between physical objects (like gas molecules) that exchange energy.
Obviously, economic interactions among people don't have physical laws like the interactions of molecules in space, but when you look at an economy as the aggregate of billions or trillions of these individual interactions, you can start to understand how patterns will emerge that almost appear to big governed by fixed rules. In other words, most people are not sophisticated buyers or sellers, and will appear -- across lots and lots of interactions -- to act in very similar manners.
In the mid-1990s, three physicists who conceived of this analogy between the physical world and economic systems got together and created a new economic framework based on their physics research. They called it The Yard Sale Model.
The Yard Sale Model
The Yard Sale Model suggests that the accumulation of wealth is not just the result of hard work and merit (which obviously plays a part), but also the result of two other key things:
1. The initial conditions of everyone in the system (where everyone starts out in terms of their financial situation); and
2. The ability for those who are more wealthy to exploit economic systems.
The idea behind #1 is that luck plays a factor in where each of us starts our financial journey. Part of this is obvious -- some are born into family and situations where they have very little financial means and others are born into better circumstances.
But, The Yard Sale Model argues that even if everyone were to start out in the exact same financial situation, luck would quickly unlevel the playing field. For example, imagine John and Linda were both new investors starting out with $1000, and each were willing to invest 20% of their net worth in order to grow their wealth. John invests his $200, gets unlucky and unfortunately loses it (hey, we all made some bad investments early on, right?); Linda invests her $200, gets lucky and doubles it.
Now John has $800 and Linda has $1200.
Again, they are each comfortable investing 20% of their net worth on the next investment. Now John is investing $160 (20% of his $800) and Linda is investing $240 (20% of her $1200). As they get more experienced and learn to make better investments and investing decisions, they have more chance of earning a profit on their investments, but John is already behind and forced to make smaller investments because he took a loss early on. And remember your percentages -- if you lose 20%, you need to earn 25% to get back to even!
Not only is John behind, but he has to make smaller investments to maintain his risk profile, and he needs a bigger return just to get back to where he started.
All other things being equal (their knowledge, experience, work ethic, luck, etc), without taking significantly more risk than Linda, John is likely to now always be behind Linda when it comes to his net worth. From a mathematical standpoint, that one unlucky investment at the beginning is going to put John at a disadvantage for a long time. Maybe forever.
(And yes, I know that all other things are rarely equal, but when talking about billions of people on the planet, things like knowledge, work ethic and risk tolerance follow some close patterns.)
The idea behind #2 is fairly well accepted, and we even have pithy quotes that we like to use to reinforce it: "The first million is the hardest" and "The wealthy get wealthier," are a couple examples. We all inherently recognize that the rich have advantages over the poor that help them stay rich and even widen the wealth gap.
And while we all kind of just know it, we can put concrete examples around it as well. Perhaps the most obvious example is compounding ability. If after that first investment, John takes his $800 and Linda takes her $1200 and they both put their money in the same investment with an annual 10% compounded return, after 20 years, Linda now has $2700 more than John.
And remember, John and Linda started out at the same spot. What if John were born into a poor family and didn't have money to eat, let alone invest. And what if Linda were born into a middle class family, where she was able to save some money growing up. There may be no reason why John can't get himself educated and improve his situation, but if Linda is starting her compounding journey at 18, while John spends 15 years just catching up to where Linda started, he is now 15 years behind on the compounding curve.
He may do fine for himself, but he will likely never catch up to Linda (again, all other things being equal).
Additionally, there are other, more systemic, advantages for the wealthy as well. For example, our tax laws in the US are very much tilted in favor of those with money. As an example, the Forbes 400 (richest Americans) had an effective tax rate of just 8.2% over the past decade (1), compared to 13.3% for the average American (2). Certainly the wealthy pay more in taxes overall, but it eats away at their wealth in smaller percentages than the average person.
Even just the ability to afford a good CPA or tax advisor can provide tremendous advantages when it comes to saving on taxes, a luxury that most Americans can't afford.
Going back to our example, not only does Linda have more money than John after just one investment, but if she were to hire a good tax advisor who can recommend some strategies to lower her tax rate (or help her defer taxes), she could much more easily widen the gap between her and John. Perhaps John works hard and hires that same advisor a few years later, but again, those few years can make a big difference.
As you can see, The Yard Sale Model of economics and wealth inequality provides some quantitative arguments for why even a little bit of luck can (and will) propel some people ahead of others. And once they are ahead, the system will likely help them stay ahead.
Of course, I kept using the example of John and Linda, with the caveat of "all other things being equal." But, that's where luck starts lose it's power. There are things John can do to bridge the wealth gap with Linda by ensuring that things aren't equal.
He can educate himself, he can work harder, he can take calculated risks, etc. At the end of the day, luck plays a role that's out of our control, but at the same time, there are many things within our control that can help us minimize the impact of these lucky (or unlucky) breaks.