Odds, Risk

How many times in your life has something unusual happened where you stopped and asked yourself, “What are the odds of that happening?”  Maybe this summer you heard about a Canadian man named Pete McCathie.  Pete has experienced three very rare occurrences in his lifetime:  being struck by lightning, his daughter being struck by lightning, and Pete has recently won a $1 million lottery prize.   All three occurrences have very low probabilities of happening once, but for one person to experience all three is exceptionally rare.  Before you ask yourself “what are the odds of that happening?” a mathematician has already worked out the answer:  the odds are 1 in 2.6 trillion.

Pete McCathie’s story is an interesting anecdote of very long odds, but it also illustrates a point about probabilities and how exceedingly rare some occurrences really are, like winning the lottery or being struck by lightning.   Let’s take a closer look at some items that regularly pop into the news and try to understand just how likely they are to occur to one of us.

If you regularly follow the news, you no doubt remember the reports this past July about the eight swimmers bitten by sharks off the coast of North Carolina.  Anyone who has seen the movie Jaws can relate to the fear of being attacked by a shark while swimming in the ocean, but what are the odds that you yourself could become a victim of a shark attack?   Based on an average lifespan of 77.6 years, and the number of shark attacks in the U.S. every year, your lifetime odds of dying from a shark attack are 1 in 3.7 million.  Maybe you are more of an “in the moment” kind of person and want to know what your odds are of being attacked by a shark attack during your next visit to the nearest U.S. beach.  Those odds are 1 in 11.5 million.

Another type of disaster that receives a lot of media attention when it occurs is a plane crash.  Plane crashes make fantastic news stories because there are usually a high number of casualties.  It isn’t hard to understand why so many people have a fear of flying after hearing so many news reports of horrific air travel catastrophes.  But what are the odds that you will perish in a plane crash during your lifetime?  According to the National Safety Council, the odds of dying in a plane crash are only 1 in 8,015 or 0.0125%.

Shark attacks and plane crashes receive a lot of sensational attention in the media, but as the data from the National Safety Council shows, you are very unlikely to die from either.  So why are people so fearful of dying in a plane crash or shark attack, but exhibit no fear of dying from more pedestrian causes?  According to the National Safety Council, the odds are much higher you will perish from a motor vehicle accident (1 in 112 or 0.89%), drowning (1 in 1,113 or 0.09%), or choking on food (1 in 3,375 or 0.03%) than you are a shark attack (1 in 3.7 million or 0.00027%) or plane crash (1 in 8,015 or 0.0125%).   So how can we explain why so many people jump in the shower, eat breakfast, and hop in their car every day without any fear of death, while at the same time there are so many people who are afraid to step into the Atlantic or Pacific Ocean for fear of ending up as a hungry shark’s next meal?

I think that at least part of the answer is that human beings in general have a difficult time fully understanding risk and probabilities in a lot of areas and applications.  And many dangers that people instinctually want to flee from or avoid, in reality pose very little threat or risk most of the time.  These instinctual behaviors probably served our ancestors very well in a much more dangerous time when the odds of dying from a venomous animal or plant were much greater than the 1 in 42,120 odds (0.0024%) we face today.  But can these hardwired instincts to flee or avoid risk actually hurt us in today’s world?  Dealing with many aspects of people’s financial lives like I do, I see where these instinctual behaviors can have a very negative impact on peoples’ financial situations.

How else can you explain why so many people who fear stock market volatility have so much money sitting in bank accounts today earning absolutely nothing?  We know that whether inflation is running at 1.5% or so annually as the Federal Government measures it today, or whether inflation is in the 11% to 12% annual range during Jimmy Carter’s last years in the White House, that there is a 100% certainty that your dollar tomorrow will be worth less than your dollar today (neglecting the small possibility of deflation, of course).    Yet people happily let themselves be bled to death financially by inflation at an annual 2%, 3% or 4% clip because they feel safer having their retirement nest egg in the bank earning nothing than they do in a well-diversified investment portfolio that allows their nest egg to keep pace with inflation.

Let us look at another potentially disastrous financial risk that most people neglect in their financial planning efforts:  the need for long-term care (LTC) insurance.  According to the U.S. Department of Health and Human Services, 70% of people older than 65 will require long-term care services at some point in their life.  Yet the American Association for Long Term Care Insurance estimates that only 8% of Americans have a plan in place to at least partially cover long-term care expenses.  We can safely assume that the cost of LTC insurance policies cannot be the only factor for not owning insurance, or more people would own policies.  It seems that many people are not aware of the high probability that they will need long-term care at some point during their lifetimes; they do not believe that they will be among the 70% who need long-term care health services during their lifetimes, or they believe they can pay for long-term care themselves should they need it.   According to Genworth Financial, the average annual cost for a private nursing home room in the U.S. was $87,600 in 2014.  It is easy to see where a three or four year stay in a skilled nursing facility can have a devastating effect on most retirement nest eggs.

More recently we have seen investors panic in reaction to a risk that has very little probability of occurring.  I’m talking of course about the investors who have sold out of their equity positions out of the fear that they will lose their retirement nest eggs in reaction to the recent market volatility surrounding China’s equity markets.   We know equity markets always come back from large selloffs and the worst bear markets.  Always!  Markets rebounded from the bear market of 2008.  The same markets rebounded from Black Monday in 1987 and from the great crash in 1927.  And the equity markets will rebound from this latest selloff.  So why have so many investors sold equities in anticipation of an outcome that has no probability of occurring?    The answer is quite simple:  irrational fear.  Fear, fueled by media sensationalism, has motivated millions of investors to take action against a threat that has absolutely no probability of occurring:  China’s stock market troubles wiping out their retirement nest eggs.

It is important to remember that there are dozens of financial risks we face throughout our lifetimes; market volatility risk is just one of these risks.  Financial plans are carefully and deliberately crafted in an effort to eliminate and reduce exposure to as many financial risks as possible, including market volatility.  Reacting to what is a perceived higher exposure to one of these risks (such as market volatility) can alter the efficacy of your financial plan, and unwittingly increase your exposure to other financial risks that can prevent you from ultimately reaching your financial goals.

So let us go back to the question, “What are the odds?”  While these incidents make for sensational headlines in our newspapers and news programs, it is very unlikely that any of you reading this will be struck by lightning, be attacked by a shark, or even win the lottery.   Likewise, if you can ignore the media hype and sensationalism around stock market drops and remember that stock markets always rebound, the odds of reaching your financial goals increase dramatically.  Remember risk and reward are related, and the promise of higher expected returns involves the risk of short-term market volatility and downturns.