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The Lighthouse Effect: Understanding the Value of Financial Planning

The Lighthouse Effect: Understanding the Value of Financial Planning

July 13, 2023

´╗┐The very first lighthouse that is known to have existed is the Lighthouse of Alexandria built on the island of Pharos in the harbor of Alexandria, Egypt. Sources vary a little as to when, exactly, it was built, but they generally agree that it was around 200-300 years BC. Coincidentally, and maybe ironically as well, it is also the tallest lighthouse known to have been built and is one of the Seven Wonders of the Ancient World.

Regardless of the features that might hold us in awe, though, why was the first lighthouse built?

That’s not a trick question—the answer is as easy as it seems because we’re all probably very familiar with the purpose of a lighthouse: to help ships navigate around coastal areas so that they don’t crash ashore. Naturally, it follows that the benefits of a lighthouse might be cited as reducing, or eliminating, the number of ships that crash upon the shore.

Price is What You Pay, Value is What You Get

Being able to define the purpose and benefit of something is great and all, but what if I asked you to tell me the value of a lighthouse? Of course, I can’t recall where, but I recently heard a quasi-definition of value that I thought put it in the right perspective: price is what you pay; value is what you get [in a transaction]. So, based on that, we can say that the transaction involved with a lighthouse involves the expenditure of time, effort, and resources to erect a lighthouse.

But what about what you get?

One answer that might come to mind would be that we get more ships making it safely to their port of destination. Well, if a ship doesn’t make it to its port of destination, and also doesn’t crash upon the shore (thanks, lighthouse…maybe), that is obviously not evidence of the fact that a lighthouse has failed. Essentially, that establishes the fact that there is more involved in a ship arriving safely at its port of destination, which means that particular data point is not exclusively attributable to lighthouses—i.e., it is a poor measure of what we get from lighthouses.

Another answer might be that we get the reduction, or elimination, of ships crashing ashore. If no ships were to crash ashore, that would be self-evident—the coast would be clear of shipwrecks. Just because evidence might be obvious, however, it doesn’t mean that the reason that evidence exists is also obvious—i.e., the cause.

What do I mean? Well, ships managed to not crash ashore before the first lighthouse was built, so not all ships were in need of the lighthouse before it arrived on the scene. If not all ships were in need of the lighthouse before it was built, then It follows that not all ships needed the lighthouse after it was built as well.

Simultaneously, however, it is safe to assume that the advent of the lighthouse at least reduced the number of ships crashing ashore. After all, if a sufficient reduction of shipwrecks wasn’t achieved, then surely only one lighthouse would have ever been built. Why build more if you don’t actually experience benefits?

What this highlights is that the problem with preventativemeasures, like a lighthouse, is that the general benefits are obvious, but the specific benefits are not. The simple reason for this is that the difference between general and specific benefits is that specific benefits have more definition, and when you’re working with numbers, definition comes in the form of quantification. Quantification is literally a matter of being able to count the specific benefits as they accumulate. It is in the counting of specific benefits that value is defined.

We arrive at this conclusion based on the definition of value given above—it’s what we get in a transaction. This means value is subjective. If something is subjective, that’s just another way of saying that it is specific to the individual at hand, whether that be a person or a ship. If something is specific to the individual, then you need to be able to tell who, exactly, experienced a benefit to be able to quantify it and define value.

That, ladies and gentlemen, is what I call The Lighthouse Effect, and it is my humble opinion that this is the precise problem that lies at the heart of preventative measures and explains why more folks don’t engage in such.

The Lighthouse Effect

At its core, financial analysis and planning ispreventative. Generally, I would define the preventative nature of financial analysis and planning as seeking to avoid the realization of risk. As was previously documented on our blog, the definition of risk that I use: the prospect that you will not have the money you need when you need it.

Obviously, money doesn’t just evaporate—there are specific things that can, and must, occur if we are to realize risk. So, financial analysis and planning are all about the very things that could potentially lead to a realization of risk and the steps that can be taken for mitigation.

Do you NEED Financial Planning?

On multiple occasions, I have been asked whether financial analysis and planning is a need. One particular instance that comes to mind is that of an insurance client from several years back. She had some questions about some decisions that she and her husband were thinking about making, and it naturally took us in the direction of talking about how to properly evaluate those decisions.

I suppose the work and cost involved with what we were discussing was what primarily caught her attention because it was after we began discussing those details that she asked about the need for analysis and planning. Her question seemed to imply that it was possible, and maybe even fairly common, that saving the effort and money associated with a proper evaluation could potentially be a more beneficial outcome than not. Coincidentally, this would also mean that making financial decisions without the benefit of proper analysis could potentially be more beneficial than not.

In essence, what we can say that we are doing when we conduct the proper analysis of financial decisions is we are engaging in a simulation. The benefit is that we gain insight into the decisions we face, and the consequences thereof, without having to actually experience consequences. You might say that it’s a bit like getting to practice decisions.

Based on all of that, a question: if we don’t have the proper analysis, then how can we define any decision in any particular way?

Basically, all we can say is that we plan to make decisions, full stop. We don’t possess what is necessary to qualify them as being best, or even whether they create greater likelihoods for success or failure. Ultimately, though, what this means is that without simulating our decisions, we are left with nothing but the actual consequences of our actions as our only means of determining whether our decisions work in our favor or not.

For obvious reasons, constantly awaiting the consequences of our decisions would seem to be a difficult way to navigate our financial lives, or at least more difficult than having the benefit of analysis. Unfortunately for some clients, this remains true, regardless of whether the perspective of a financial advisor is sought.

The way that I know this to be true is the simple fact that I have been asked questions that can only be answered with the benefit of analysis, yet the clients asking the questions don’t want to engage in the proper analysis and planning. This would seem to betray a belief that advisors don’t merely interpret analysis, but that they are also capable of operating outside of it.

There’s a slight problem with this belief, though, because psychics aren’t real, crystal balls don’t allow you to see the future, and genies are just ordinary people in costume who can’t actually grant wishes.

Having established that the future remains open-ended, let’s turn our attention to hindsight. If we achieve success without the proper analysis or planning, is that evidence that they weren’t needed? In other words, would the perceived success of our plan be evidence that not pursuing analysis or planning was the best decision, to go along with the other decisions we make along the way?

Those questions highlight The Lighthouse Effect in action in the financial realm. We can take it a step further, though, because we can also say that some people have obvious issues that necessitate analysis and planning. So...

...just like the fact that ships once crashed ashore on a sufficient basis to merit lighthouses, we know, as a general rule, that there are people who experience financial hardships that are directly attributable to their financial decision-making.

What we can’t know ahead of time, however, without the benefit of the proper analysis of individual situations, is who, specifically, is at risk of having such an experience.

That includes you.