“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
― Ernest Hemingway
Financial planners love numbers. They want some sort of quantifiable way to tell you whether or not you’re going to succeed in goals. Like the weatherman who says that there’s a 30% chance of rain (how come it’s never 38.73%?), financial planners want to give you a number that is the summation of all of their prognostications about what the future holds for you.
I am one of these. Step 1: admit you have a problem.
I am a self-confessed modeling junkie. I even co-authored a case study on Markov chain modeling when I was in business school. I enjoy Monte Carlo analysis. When I work with clients, I ask them all of the questions about their hopes, dreams, and fears. I have them too. I hope all of their hopes revolve around retiring early and globe hopping so that we’ll have a lot in common to talk about!
But, secretly, I want to get down to numbers. I want to get into nitty gritty about expenses, earnings, probabilities, returns, assumptions, and everything else that makes a quant jock tingle. When this happens to you, don’t get offended. I like you. I won’t work with someone I don’t like. I swallowed the distasteful too many times in my previous business to want to do the same thing again, so I get to choose this time. Therefore, if I work with you, I like you. I do care about your hopes, dreams, and goals.
But I really, really enjoy numbers and modeling. So, at some point in our relationship, I’m going to build some models about you, your family, your life, and all of the permutations that could potentially happen to you, both good and bad.
At the end, once I am done playing mad scientist, I will return with some projections. The projections will take the form of a discussion which will tell you that based on your current state, a set of assumptions, and a bunch of randomly chosen outcomes – which is what Monte Carlo analysis is – that the projected outcomes mean that you have an X% chance of succeeding if you follow the plan that we’ve discussed.
“X%!” you’ll cry out. “Why don’t you give me a number instead of a letter?”
- There will be a number instead of a letter. What I’ll be telling you, though, is that there’s a certain probability that you will have enough money when the Grim Reaper comes calling so that you can hit your life goals, such as…
- Leaving a certain amount of inheritance to the kids
- Giving to charities
- Not dying broke
- Any other number of goals you may have in life which involve not eating cat food and becoming the bag lady
Let’s say that the number comes out to 81.3%. Based on what you will have told me you want to do, what you make, your savings rate, and a bunch of other things, I determine that you have an 81.3% chance of succeeding.
That 81.3% is not binary, though. Neither is the 18.7% where you don’t succeed. That’s why it’s important to look at ranges of outcomes. While that number is a cutline for what you have defined as success, it does not tie you in to a given outcome. For example, in the 18.7% where you don’t succeed, there might be a scenario where you wind up $5,000 short. While it’s defined as a failure in the model, it’s probably not really a failure in real life because you’ll adjust your behavior accordingly. Furthermore, as research from the University of Pennsylvania shows, we are fairly good at predicting magnitude of negative impacts but we’re not as good at predicting the actual probability of such impacts. As a result, we’ll probably wind up overcorrecting on the conservative side, as a fear of becoming the bag lady will overwhelm our actions.
So, when it comes time to evaluate the outcomes, think not only about what you’re doing now to set yourself up to get to your goals, but think about what you can do in the future.
If things go particularly rosy, you could:
- Increase your standard of living
- Give more
- Leave more to the kids
- Invest less aggressively to preserve capital and income
However, if they turn south, you could:
- Decrease your standard of living
- Delay retirement
- Tell the kids to fend for themselves. You’re spending their inheritance!
- Donate time instead of money
Financial planning is a continuous process. It’s not one where you take a point in time, measure, and then live the rest of your life rigidly on that single line. I can run a hundred thousand scenarios in my Monte Carlo model, and I can assure you of one thing: none of the modeled scenarios will match what happens in your life.
That’s why it’s important to do the occasional check in to see where you are in your plan and to see what, if any, adjustments need to be made. You aren’t just a number.
Please note: I am not a mad scientist. There really is method behind the madness!