Most people don’t know how to accurately assess the probabilities and risks in their financial planning. As a result, their financial plan will likely collapse the moment something goes wrong. What does it mean almost always falls apart because there are a million things in life that we don’t anticipate, don’t take into account, or just forgot to take into account.
It’s not that planning is pointless. We need to treat planning as a process and not as a one-time event that we set and forget. We also need strategies for building stronger financial plans that can withstand the inevitable bad luck, bad decisions, or poor assumptions that happen along the way.
You don’t have to predict the future to make a better plan. At our financial planning firm, we don’t try to be right all the time. Instead, our goal is to give risk – in investing and in life – the respect it deserves and create sound financial plans that take into account how probabilities actually work. Here’s how to do the same.
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1. Avoid false feelings of security
The average person (and even those who are mathematically inclined) tends to have trouble applying probability to real-world scenarios. We saw this vividly illustrated after the 2016 election when people were shocked that Donald Trump won. The best pollsters gave him about a 30% chance(opens in new tab) a positive result. «Not so likely» does not mean «impossible».
Most people equate this with a lower probability of success no Probability of success, but a 30 percent chance of something happening is very, very different from a zero percent chance.
So, to create a more solid financial plan, you cannot rely on models that give you a «probability of success» as a final seal of approval. Monte Carlo simulations are very helpful, but can also be incredibly misleading. This is especially true the younger you are, when variables have more time to play out in different ways than you thought they would.
Avoid looking at situations where a mathematical formula says you have a 70% chance of succeeding and thinking you’re ready. It’s certainly a good indicator that you’re on the right track, but to create a strong plan requires you to keep re-evaluating over time — and realizing that what’s likely isn’t the same as guaranteed or risk free.
2. Think carefully about your assumptions and choose actions that you can stick to consistently
Planning can account for the potential occurrence of downside risks by avoiding the use of aggressive assumptions. I love this paraphrased quote that came from CFP, Author and Speaker Carl Richards(opens in new tab) at a financial planning conference: Risk is what shows up after you think you’ve thought of everything.
That said, one thing you forgot to include in the plan is the thing that’s most likely to come up and throw you off! However, you cannot possibly account for every reality that will occur. What you can do is make reasonable assumptions not based on everything going your way. It’s not necessarily about «conservative» planning. The way you create a foolproof financial plan is over planning (opens in new tab) consequent.
For example, if you’re in your 40s and at the peak of your career and years of service, you might expect your fast-growing salary to keep increasing over time. Maybe you’re expecting 5% to 7% increases every year (because that’s what you’ve seen over the past few years).
However, that may not be sustainable for another 10, 15 or 20 years. If you use this assumption and your income growth slows or falls, your plan may not work. So instead of using an aggressive assumption, we could simply assume lower income growth over time (e.g. 2.5%).
You don’t always have to assume a worst-case scenario… but you can’t assume it best with any variable either. By moderating what you expect, you can create a plan that works regardless.
Here’s a quick overview of some of the assumptions that go into a plan:
- Earnings and how long you expect to work or receive a specific salary.
- Cost of living now and in retirement.
- Investment returns and your investment horizon.
- Inflation.
- Specific goals and their costs and timelines.
Depending on the variable, you may want to underestimate (as with income and investment returns) or overestimate (as with spending or inflation) your expectations.
3. Remember that life happens outside of spreadsheets
Any financial plan is only as good as the information you put into it. You can create many scenarios on paper; If you’re good with spreadsheets, you can pull the numbers to tell you the story you want to hear. But spreadsheets don’t capture the context of your everyday life.
The quality of this time is important because it is how you actually experience your life: in the short term as your present self. In the meantime, your financial plan requires you to make long-term decisions for the good of your future self. This is a «self» that you don’t know at all.
A strong plan recognizes this friction and addresses it find the balance between enjoying life today and planning responsibly for tomorrow.
4. Don’t rely on a single factor to lead you to success
Watch out for aggressive or overly optimistic assumptions, not just reasonable ones, and be aware of how much weight you give to any single factor in your plan. It’s like your investment portfolio: diversify instead of putting all your eggs in one basket!
These scenarios are common when customers try to over-rely on a single variable:
- Continuously reliant on large bonuses, commissions or targeted earnings.
- Expect to receive consistent equity rewards over time through refresher grants (which aren’t really guaranteed).
- Based on a projected pension payment in 20 years (and not taking into account what happens if you change careers).
- Waiting for an IPO that may not happen and a high stock price that may fluctuate.
It may be okay to project these for a year or two, but relying on them for the next 10, 20, or 30 years is setting a plan for failure.
If you expect bonuses, commissions, or targeted income to increase your salary by 100%, plan for 50%. If you have a pension, extrapolate your retirement income using the pension amount you are guaranteed today and the projected retirement income you would receive if you worked another 20 years with the company.
If you get RSUs Consider these today, but don’t count on additional grants for the next five years. If you’re expecting an IPO… don’t! That’s totally out of your control, and you can’t create a complete financial plan based on the assumption that (a) your company will go public and (b) you’ll benefit handsomely when it does.
5. Exchange Account
Plans with a high probability of success Build in a natural buffer (opens in new tab) for life changes. These changes could be external in nature, beyond your control, such as B. economic recessions that lead to corporate layoffs or pandemics, or other natural disasters that shut down economic growth (and therefore your investment returns).
Other factors might be within your control, and these aren’t necessarily bad things. You might just change your mind about your job, your life situation, or your goals. Personal or family dynamics can change in unpredictable ways, which can seriously affect your financial plan.
I experienced this personally when my wife and I decided to have children. For years we’ve been on the fence (and even inclined to voluntarily childfree). Our financial plan reflected our current reality; We had no goal of «saving for college» or considering the generally higher cash flow we would need to support the expenses of a larger family.
However, what we did do was build a buffer space into our plan. Our specific strategy was to set a very aggressive “retirement target”; we planned as if we would stop receiving income when I turned 50. Actually I didn’t do that want to retire so early. I love my job and my business and assuming that all of our income would abruptly stop and we would start living off our investments at that point was pretty unlikely.
But this version of the plan required a very high savings rate for it to work, and we stuck to it, even though we didn’t think we would retire that early. This intense rate of savings over many years allowed us to turn around when we decided to have children.
We’ve adjusted the plan by pushing back our retirement age and lowering our current savings rate. We were able to afford this move because we’d saved so much many years earlier, and reducing our savings rate freed up cash flow to manage spending on a new baby (and to fund new priorities like college savings).
Without the right buffer space in the plan, the plan collapses and may even fail in ways that cannot be easily recovered. We want to avoid this mistake when planning.
The point is that change isn’t always bad, but it almost inevitably happens in some form. A strong financial plan is one that allows for a turnaround without forcing you to give up what matters most to you.
