The Rich Uncle Scenario
AKA: The Economic Value of Certainty

Certainty in investing?  What does that mean?  Shouldn’t you just look for an investment that offers a high rate of return now so that you will have income during retirement?  There is a place for those type of investements – right after you have created certainty in your financial life.  Here is a story to illustrate this point.

Suppose you had a very rich uncle who one day came to you and had the following conversation:

Uncle: “I am proud of you.  I have been watching your life over the last few years and I really like what I see.  It is obvious that you are going somewhere.  You are bright, hard working, and innovative.  I see that you have a really bright future ahead of you and I would really like to help out.  So I have set up a trust fund for you at the bank here in town and I put $5,000,000 (five million) dollars in it.  It has your name on it so that five years from today all you have to do is walk into the bank, sign the paperwork and the money is yours.”

You: “uuuhhhh… Are you serious!?”

So you get in your car, race down to the bank to see if it is true.  And it is.  There is, in fact, $5 million dollars in the account with your name on it.  And the paperwork really does say that in five years all you have to do is come in and sign to get the money. 

If that really happened to you, would anything change about your life right now today?  And if so, what would change?  For most people the answer is a resounding yes, things would change immediately.  Think about some of these questions: Would you spend as much time worrying about retirement?  Would you shop differently?  Would you continue contributing to your 401k or IRA? Would you stay at your current job?  Would you try things in your business you have been afraid to do?  Would you daydream about what you will do with the money when you get it?  Would you spend money any differently than you do right now? 

Even though the money will not be received for five years, the effect begins immediately.  For most people their world changes pretty dramatically.  For some, perhaps, the only thing that changes is that they simply don’t think about money issues as much. 

Now think about your rich uncle again.  This time he comes to you and has a similar but slightly different conversation:

Uncle: “I am proud of you.  I have been watching your life over the last few years and I really like what I see.  It is obvious that you are going somewhere.  You are bright, hard working, and innovative.  I see that you have a really bright future ahead of you and I would really like to help out.  So I have been thinking about maybe setting up a trust fund for you down at the bank and putting some money into it…”

And that’s the end of the conversation.

What changes now?  Probably nothing, right?  If anything, it might trigger some more questions for you: Was he serious?  How much money is he thinking of putting in there?  Will he really do it?  When?  What if something happens to him or his business?  The only real change in your life right now is that you may start sending him a little bit better Christmas card each year.

Now imagine a third scenario with your rich uncle:

Uncle: “I am proud of you.  I have been watching your life over the last few years and I really like what I see.  It is obvious that you are going somewhere.  You are bright, hard working, and innovative.  I see that you have a really bright future ahead of you and I would really like to help out.  So I have set up a trust fund for you at the bank here in town and I put $5,000,000 (five million) dollars in it.” 

You: “uuuhhhh… Are you serious!?”

So you get in your car, race down to the bank to see if it is true.  And it is.  There is, in fact, $5 million dollars in the account with your name on it.  But this time the paperwork is a little bit different.  The paperwork says that five years from now the bank will give you a quarter and you have to flip it.  If it lands heads you get $5 million dollars.  If it lands tails you get absolutely nothing!

What changes in this third scenario?  50/50 odds are pretty good.  If you were in Vegas you would play that game all day right?  But can you plan your future based on 50/50 odds?  And if you do try to build a plan, what is your plan B in case the odds go against you?  And does your life change right now today, or do you wait until you have flipped that coin to be sure whether the money is yours or not before you start planning anything?

So what is the only difference between these three scenarios?  Certainty.  That’s it.  In the first example you had 100% certainty.  You knew how much and you knew exactly when the $5 million was yours.  Life changes immediately with this scenario.  You can make plans for the future and even live your life differently right now.

In scenario two there was 0% certainty.  You had no idea if or when or how much you would ever receive.  In this scenario nothing changes with your life now or in the future.  The only changes will probably be negative, like increased anxiety and nervousness because you have no idea what the future holds.

In scenario three there was 50% certainty.  Not bad if you are gambling, but hard to build a life around.  You may or may not have the money in the future, and either option is just as likely as the other to happen.  Does life change today?  No except, perhaps, the increased anxiety of again not knowing what the future holds.

So what does this have to do with your financial life?  Think about your current retirement plan.  Which scenario above does your 401k most closely resemble?   How about your stock portfolio?  What about your pension plan?  Mutual fund?  Real estate holdings? 

When you begin to invest money or plan for retirement, you should do those things that will create the most amount of certainty FIRST before anything else.  Only then should you begin to look for ways to increase rate of return, or growth.  Unfortunately, the majority of people do exactly the opposite and chase rates of return and investment growth first and then worry about creating the certainty later (if at all).  Not coincidentally, most people are also extremely anxious about what their later years will look like, not to mention the stress it causes in their lives today.  It is an often overlooked irony that chasing high rates of return first is often a recipe for financial failure, while creating certainty first actually produces higher rates of return in the end.

 
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