Almost any financial decision that you have to make can be compared to playing chess, playing roulette, or playing poker.
Chess is a game of pure skill. All possible information about the game is equally available to both opponents and neither player can hide anything from the other. Because the game is purely analytical, we’ve seen several occasions where a computer has beaten a world class chess master. But because there’s no such thing as luck in chess, it would be virtually impossible for a beginner to beat the master.
At the other end of the spectrum is roulette, a game of pure luck. Despite what you may try to tell yourself, you don’t have any information to work with. There’s no skill that you can bring to the table to improve your chances. A first-time player is on equal footing with a chain-smoking degenerate gambler who goes to the casino every day.
And somewhere in between we find poker. Poker combines both luck and skill because the game includes information that you know (like the cards in your hand) and information that you don’t know (like which cards your opponents hold). More often than not, a highly skilled poker player will beat a novice, but sometimes the novice will win if he stumbles across a lucky hand that’s so strong that it can’t be overcome by the skill of the experienced player.
All of your financial decisions fall into these same three categories—pure skill, pure luck, or some of both. A few examples…
Roth Conversions – You can convert money from a traditional IRA (money that’s yet to be taxed but will be taxed upon withdrawal) to a Roth IRA (where it will grow tax-free and can be withdrawn tax-free later). You’ll just have to pay the taxes at the time of the conversion.
This is chess. All information is available to you. If you do a Roth conversion in December, you know at that point what your income is going to be for the year, and you know exactly what the tax brackets look like. From there, it’s easy to see how much it’s going to cost you in taxes to do this conversion and you can decide whether or not it’s logical to pay those taxes now so that the money will be available tax-free for you later.
Timing the Market – Many people are convinced that they can time the market, meaning that they can “sell high” right before a crash happens, then “buy low” and put their money back in right before the market recovers. Unfortunately for them…
This is roulette. It’s true that there are people who have successfully timed the market before. Of course, there are also plenty of people who have had a really good day at the roulette wheel. Both of these people have benefitted from luck, not skill. To successfully time the market, you have to be right twice—you have to sell at exactly the right time, but then you have to buy back in at exactly the right time too. And no matter what chart you’re looking at or what data you think you’ve mastered, nobody knows where the market roller coaster is going to go next.
It’s also important to note that just because somebody successfully timed the market once before, that’s no indication of their ability to successfully do it again. Just like the guy who won at roulette on Friday night…he walks into the casino on Saturday with the same chance of winning as the guy who lost his shirt the night before.
Deciding on a Retirement Date – Occasionally, people will be forced into retirement, maybe by a health issue, or perhaps by a company or industry telling them that it’s time to move on. But most of the time, you have to decide whether or not it’s the right time for you to walk away from that paycheck.
This is poker. There’s a lot of information that you know…like how much money you’ve saved, how much you want to spend, and what guaranteed income streams (like Social Security or pensions) will be available to you. On the other hand, there’s plenty that you don’t know, like how long you’ll live, how your investments will perform in the future, and what kind of health problems you might face down the road.
So anytime you’re faced with a financial decision, determine if it’s a decision that requires you to play chess, roulette, or poker.
If it’s chess, you should seek guidance…because skill and experience always wins at chess.
If it’s roulette, you should determine if there’s another way to approach the situation so that you aren’t forced to play a game of pure luck.
If it’s poker, you should stack the deck. Find ways to reduce the areas of uncertainty and increase the things that you know. In other words, reduce the reliance on luck and increase the opportunity to employ skill.
And then all that’s left to do is enjoy the game…