Most people don’t know how to accurately assess probabilities and assess risks in their financial planning. As a result, their financial plan is in danger of collapsing as soon as something goes wrong. Which means almost still is collapsing, because there are a million things going on in life that we can’t foresee, that we haven’t taken into account, or that we have simply forgotten to take into account.
It’s not that planning is useless. It’s that we need to treat planning as a process, rather than a one-time event that we set and forget. We also need strategies to build stronger financial plans that can actually withstand the inevitable bad luck, bad decisions, or bad assumptions that happen along the way.
You don’t have to predict the future to come up with 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 investments and in life – the respect it deserves and to build sound financial plans that recognize how probability actually works. Here’s how you can do the same.
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1. Avoid false feelings of security
The average person (and even those with a mathematical bent) tends to have trouble applying probability to real-life scenarios. We saw this clearly illustrated after the 2016 election, when people were shocked that Donald Trump won. The best sounders gave him about a 30% chance (opens in a new tab) of a positive result. “Not as likely” does not mean “impossible”.
Most people equate a low probability of success with Nope probability of success, but a 30% probability of something happening is very, very different from a 0% probability.
To build a more solid financial plan, you therefore cannot rely on models that give you a “probability of success” as the ultimate seal of approval. Monte Carlo simulations are very useful, but they can also be incredibly misleading. This is especially true the younger you are, when there is more time for variables to play out in different ways than you might have assumed.
Avoid looking at situations that have a mathematical formula that 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 developing a solid plan requires you to continually reassess over time and recognize that what’s likely isn’t the same as guaranteed. or without risk.
2. Consider Your Assumptions Carefully and Choose Actions You Can Track Consistently
Planning can take into account the potential for downside risk by avoiding the use of aggressive assumptions. I love this paraphrased quote from CFP, author and speaker Carl Richards (opens in a new tab) at a conference on financial planning: Risk is what appears after you think you’ve thought of everything.
This means that that thing you forgot to factor into the plan is the thing that is most likely to pop up and throw you into a loop! However, you cannot account for all the realities that will occur. What you can do is use reasonable assumptions that aren’t based on everything that goes your way. This is not necessarily about planning “conservatively”. The way you build a foolproof financial plan is by planning (opens in a new tab)regularly.
For example, if you’re in your 40s and at the peak of your career and earning years, you can expect your fast-growing salary to continue to increase over time. Maybe you expect to see increases of 5% to 7% each year (because that’s what you’ve seen over the past few years).
However, this may not be viable for another 10, 15 or 20 years. If you use this assumption and your revenue growth slows or declines, your plan may not work. So instead of using an aggressive assumption, we could just assume lower income growth over time (such as 2.5%).
You don’t need to assume a worst-case scenario every turn… but you can’t assume that the better neither with each variable. By moderating what you expect, you can build a plan that works regardless.
Here is a brief overview of some of the assumptions that go into a plan:
- Earnings and how long you expect to work or earn a certain salary.
- Living expenses now and in retirement.
- Investment returns and your investment time horizon.
- Inflation.
- Specific objectives and their costs and deadlines.
Depending on the variable, you may want to underestimate what you expect (as with revenue and ROI) or overestimate (as with expenses or inflation).
3. Remember that life happens outside of spreadsheets
Any financial plan is only as good as the information you plug into it. You can run a lot of scripts on paper; If you’re good with spreadsheets, you can get the numbers to tell you the story you want to hear. But spreadsheets don’t capture the context of your daily life.
The quality of this moment is important, because this is how you really live your life: as yourself, in the short term. Meanwhile, your financial plan forces you to make long-term decisions for the benefit of your future self. It is a “self” that you do not know at all.
A solid plan recognizes these frictions and aims to find the balance between enjoying life today and planning responsibly for tomorrow.
4. Do not depend on a single factor for success
In addition to using reasonable assumptions rather than aggressive or overly optimistic assumptions, be careful about how much importance you place on a factor in your plan. It’s like your investment portfolio: Diversify rather than putting all your eggs in one basket!
These scenarios are common when we see customers trying to rely too much on a single variable:
- Constantly rely on large bonuses, commissions or targeted earnings.
- Expect to receive equity compensation consistently over time via retraining grants (which are not actually guaranteed).
- Using a projected pension payout 20 years from now (and ignoring what happens with a career change).
- Waiting for an IPO, which may not happen, and a high stock price, which may fluctuate.
It may be okay to project them for a year or two, but to rely on them for the next 10, 20 or 30 years is setting a plan for failure.
If you expect bonuses, commissions, or targeted earnings to add 100% to your salary, expect 50%. If you have a pension, project your retirement income with the amount of pension guaranteed to you today versus the projected pension income you would receive if you worked for the company another 20 years.
If you’re getting RSUs today, take that into account, but don’t plan on additional grants for the next five years. If you’re expecting an IPO…don’t! It’s completely out of your control, and you can’t build a complete financial plan assuming that (a) your business will have an IPO, and (b) you’ll make big profits if it does.
5. Accounting for change
Plans that have a high probability of success fit into a natural buffer zone (opens in a new tab) for life changes. These changes could be external in nature, which are beyond your control, such as economic recessions that lead to business layoffs or pandemics or other natural disasters that halt economic growth (and, therefore, your returns on investment. ).
Other factors could be within your control, and these are not necessarily bad things. You might just change your mind about your career, life situation, or goals. Personal or family dynamics can change in unpredictable ways and significantly affect your financial plan.
I personally experienced this when my wife and I decided to have children. For years, we were on the fence (and even leaned into being childless by choice). Our financial plan reflected our current reality; we didn’t have a “save for college” goal or an account for the generally higher cash flow we would need to manage the expenses of a larger family.
What we did, however, was build a buffer zone into our plan. Our specific strategy was to set a very aggressive “retreat” target; we planned as if we were going to stop receiving income when I turned 50. In fact, I don’t have want to retire so soon. I love my job and my business, and to assume that all of our income would come to a screeching halt 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, which we stuck to even though we didn’t think we were likely to retire so young. This intense savings rate for many years allowed us to pivot when we decided to have children.
We adjusted the plan by raising the retirement age and reducing our current savings rate. We could afford to make this change because we had saved so much for many years before, and reducing our savings rate freed up cash to handle the expenses of a new baby (as well as to fund new priorities , such as college savings).
Without the right buffer in the plan, the plan breaks and maybe even fails in a way that does not allow for easy recovery. We want to avoid this failure when we plan.
The point is, change isn’t always bad, but it almost inevitably happens in one form or another. A solid financial plan is one that allows a pivot without forcing you to give up on what’s most important to you.
This article was written by and presents the views of our contributing advisor, not Kiplinger’s editorial staff. You can check advisor records with the SEC (opens in a new tab) or with FINRA (opens in a new tab).
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