The millionaire next door, fooled by randomness?

The millionaire next door, fooled by randomness?

The Millionaire Next Door was one of the first personal finance books I read–or at least listened to. I found it generally enjoyable, and I think the data/case study format appealed to my inner engineer. More recently, I read Fooled by Randomness, which, to my surprise and appreciation, explains the survivorship bias that flaws The Millionaire Next Door. This post walks through the bias, and how both books can still be helpful to those pursuing financial independence.

The millionaire next door

In The Millionaire Next Door (TMND), Stanley and Danko present the traits common to many millionaires. To summarize the book in a sentence, most millionaires accumulate wealth by being frugal and making good investment and/or business decisions. The TMND message is positive overall, since it encourages responsible spending and saving habits. But is their analytical approach sound?

Fooled by randomness / survivorship bias

In Fooled by Randomness (FBR), Taleb explains that most of what we see in finance, and life in general, is a result of random outcomes from a large sample size. We tend to see only spectacular outcomes–usually spectacularly positive outcomes–because of survivorship bias. He identifies two forms of survivorship bias in TMND that are important to recognize:

  1. “Visibility winners.” Only successful people were sampled, so we can’t determine how many people displayed the same traits as the rich, but made the wrong investment decisions. Living below one’s means but accumulating horrid assets will not yield a millionaire.
  2. “It’s a bull market.” Most of the millionaires achieved their status through period-specific asset price inflation. Projecting these returns forward could disappoint current and future accumulators of wealth.

Taleb makes the point numerous times in the book that due to the survivorship bias, “the highest performing realization will be the most visible.” This is especially true for a book that specifically seeks out successful people.

Taking it a little further with a simplified example, we know many small business owners are wealthy and would make it into TMND’s sample set. However, we also know many small business owners have gone broke (or worse). If 50% of small business owners end up with $1M and 50% end up broke, the expected wealth of a small business owner is $500k, not the $1M you might infer from TMND.

It is important to consider all possible outcomes, not just the most visible ones, when formulating your investment plan. Beware the survivorship bias in all sources of information. That includes this blog.

The stoic investor

After reading FBR, I don’t think Taleb has a problem with the wealth building strategies used by those in TMND (although see below for an aside on his issue with frugality for frugality’s sake). I think he only takes issue with Stanley and Danko reporting on the success–and only the success–of those strategies. Later in the book, Taleb describes stoicism as follows:

That is what stoicism truly means. It is the attempt by man to get even with probability…

The stoic is a person who combines the qualities of wisdom, upright dealing, and courage. The stoic will thus be immune from life’s gyrations as he will be superior to the wounds from some of life’s dirty tricks.

N.N. Tableb, Fooled by Randomness

Based on this narrative, I believe the millionaires-to-be in TMND were stoic investors, something Taleb would probably respect. They had no way of knowing if their investment or business decisions would succeed. Nonetheless, they delayed gratification and committed their savings to uncertain (and I expect at times volatile) investments. They took the risk and reaped the reward. But by reporting on their success after the fact–and without regard for the losers–TMND may unintentionally mislead some readers. Far less stoic.

Lessons from both books

Although I believe FBR is more comprehensive than TMND, I still recommend both books. I also incorporate lessons from both books into our financial plan:

  1. From TMND: we live well below our means and invest the difference according to our investor policy statement.
  2. From FBR: consider survivorship bias, and all possible outcomes, when making investment decisions. Understand that what may have worked for some people may have also backfired for others–and the latter will be far less visible in the history books (or blogs). Also remember that what has worked in the past may not work in the future.
  3. From FBR: approach investing with stoicism. Stick with the investment plan through thick and thin.

When building wealth, you can only control two things: how much you invest (TMND), and what you invest in (FBR and Taleb’s other books). You can’t control how well the investments do. But you can know that if you invest twice as much, you’ll be twice as rich (unless your investments lose 100% of their value, in which case you’re screwed either way). You can also bet that someone else will invest better than you and achieve greater wealth. But you won’t see how much risk they took or the success rate of their approach. Thanks to the survivorship bias, you’ll just see their success. And actually, it is even worse than that. You’ll also probably hear about their investing skill, even though their success was just the result of a large sample size in a largely random market.

To avoid going insane, I recommend focusing on only the two things you can control: how much you invest, and what you invest in.

A brief aside on frugality for frugality’s sake

In the section of FBR where Taleb critiques TMND, he makes it clear that he is not impressed by wealth:

…I see no special heroism in accumulating money, particularly if, in addition, the person is foolish enough to not even try to derive any tangible benefit from the wealth (aside from the pleasure of regularly counting the beans).

N.N. Taleb, Fooled by Randomness

I can agree with this statement, but with a point of clarification. I believe many people on the path to financial independence, myself included, do derive pleasure from money unspent. The pleasure comes in the form of knowing we have shortened our forced working careers by that much more. We of course also derive pleasure when we spend money according to our values (such as travel), and do not pinch pennies on things that are important to us. Saving and spending with purpose is key to financial independence.

If you want to buy either book after reading this post, please use my affiliate links

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