Most people do not know how to accurately assess probabilities and evaluate risks in their financial planning. As a result, their financial plans are likely to fall apart when something goes wrong. Which means almost always fall apart, because there are a million things that happen in life that we cannot predict, do not account for or just forget to consider.
It’s not that planning is pointless. It’s that we need to think of planning as a process, rather than a one-time event that we set and forget. We also need a strategy to build a strong financial plan that can actually withstand the inevitable bad luck, bad decisions or bad assumptions that happen along the way.
You don’t need to predict the future to build 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 build a solid financial plan that recognizes how probabilities actually work. Here’s how you can do the same.
1. Avoid a False Sense of Security
Average people (even the mathematically inclined) tend to struggle with applying probability to real-life scenarios. We saw that vividly depicted after the 2016 election when people were surprised that Donald Trump won. The best pollsters give him about 30% chance (opens in new tab) of positive results. “Not likely” does not mean “impossible”.
Most people equate a lower probability of success not probability of success, but 30% chance of something happening is very, very different from zero percent chance.
To build a stronger financial plan, you can’t rely on a model that gives you “probability of success” as a stamp of approval. Monte Carlo simulation very helpful, but they can also be incredibly misleading. This is especially true when you’re younger, when there’s more time for variables to play out in different ways than you might think.
Avoid looking at situations where mathematical formulas tell you that you have a 70% chance of success and think you’re all set. That’s a good indication that you’re on the right track, but building a solid plan requires you to constantly reassess as time goes on — and recognize that the odds aren’t the same as guaranteed or free.
2. Consider Your Assumptions Carefully and Choose Actions You Can Stick With Consistently
Planning can account for potential downside risks that appear by avoiding the use of aggressive assumptions. I love this paraphrased quote that comes from it CFP, author and speaker Carl Richards (opens in new tab) at a financial planning conference: Risk is something that shows up after you think you’ve thought of everything.
Meaning, the one thing you forget to plan for is the most likely thing to pop up and throw you for a loop! You can’t account for every fact that will happen, though. What you can do is use reasonable assumptions that aren’t based on anything you run into. This is not necessarily about “conservative” planning. The way you build a foolproof financial plan is by design (opens in new tab)consistently.
For example, if you’re in your 40s and in the prime of your career and earning years, you can expect your fast-moving salary to continue to grow over time. Maybe you’re expecting a 5% to 7% rise every year (because that’s what you’ve seen over the last few years).
That might not be sustainable for another 10, 15 or 20 years, though. If you use that assumption and your income growth slows or declines, then your plan won’t work. So instead of using aggressive assumptions, we can simply assume a smaller increase in income over time (like 2.5%).
You don’t have to assume the worst case scenario every time… but you can’t the best with each variable either. By moderating what you expect to happen, you can build a plan that works regardless.
Here’s a quick rundown of some of the assumptions that go into the plan:
- Income and how long you expect to work or make a certain salary.
- Cost of living now and in retirement.
- Investment returns and your investment time horizon.
- Specific goals and costs and timelines.
Depending on the variables, you may want to underestimate what you expect (as with income and investment returns) or overestimate (as with expenses or inflation).
3. Remember That Life Happens Outside Spreadsheets
Any financial plan is only as good as the information you post. You can create many scenarios that work on paper; if you’re good with spreadsheets, you can get numbers to tell the stories you want to hear. But spreadsheets don’t capture the context of your everyday life.
The quality of that time is important, because that’s how you really experience your life: as yourself now, in the short term. Meanwhile, your financial plan requires you to make long-term decisions for your future self-interest. That “self” you don’t know much about.
A strong plan recognizes that friction and aims find balance between enjoying life today and planning responsibility for tomorrow.
4. Don’t Rely On A Single Factor To Get You Success
Along with using reasonable assumptions instead of aggressive or overly optimistic, be careful about how much weight you put on any one factor in your plan. This is like your investment portfolio: Diversify instead of putting all your eggs in one basket!
This scenario is common when we see clients trying to rely more on a single variable:
- Continue to rely on large bonuses, commissions or earnings on target.
- Expect to receive equity compensation consistently over time through refresher grants (which are not guaranteed).
- Using projected pension payments 20 years from now (and not considering what happens with a career change).
- Waiting for an IPO, which may not happen, and high stock prices, which may fluctuate.
It may be OK for this project to come out for one or two years, but relying on them for the next 10, 20 or 30 years has set the plan up for failure.
If you expect bonuses, commissions or earnings on target to add 100% to your salary, project 50%. If you have a pension, project your retirement income with the guaranteed pension amount today vs the projected pension income that will be received if you work for another 20 years in the company.
If you win RSUs today, the opinion factor in, but do not project additional grants for the next five years. If you’re hoping for an IPO… don’t! It’s completely out of your control, and you can’t build your entire financial plan on the assumption that (a) your company will have an IPO, and (b) you’ll make a fortune if it does.
5. Account for Change
A plan that has a high probability of success build on natural buffers (opens in new tab) for life change. Those changes may be external in nature, beyond your control, such as an economic recession that causes company layoffs or a pandemic or other natural disaster that shuts down economic growth (and, therefore, your investment returns).
Other factors may be within your control, and this is not necessarily a bad thing. You can simply change your mind about your career, life situation or goals. Personal or family dynamics can move in an unpredictable way that can throw a major wrench into your financial plan.
I experienced this personally when my wife and I decided to have children. For years, we were on the fence (even leaning towards being child-free by choice). Our financial plan reflected our current reality; We don’t have the goal of “saving for college” or account for the generally high cash flow we have to manage large family expenses.
What we did, however, was build a buffer room into our plans. Our special strategy was to set a very aggressive “retirement” goal; we planned as if we would stop receiving income when I turned 50. In fact, I didn’t want retirement is early. I love my job and my business, and to think that all our income will stop and we will start living off our investments at that time is impossible.
But that version of the plan required a very high level of savings to make it work, which we did even though we didn’t feel like we’d be retiring very young. That strong savings rate over the years allowed us to pivot when we decided to have kids.
We adjusted the plan by pushing our retirement age out and reducing our current savings rate. We can afford to make that move because we saved so much during the previous few years, and reduced the rate of our savings to free up cash flow to manage new baby expenses (as well as to finance new priorities, like college savings).
Without proper buffer room in the plan, the plan breaks down and may fail in a way that does not allow for easy recovery. We want to avoid this failure when we plan.
The point is that change is not always bad, but it is almost inevitable in some shape or form. A strong financial plan is one that allows you to pivot without forcing you to give up what is most important to you.