Foundational Tenets Of My Approach To Financial Planning
In my past articles, I have thrown light on the way I view and perceive various aspects of financial planning. My approach to financial planning is also clearly explained here on my website. But I have never really spoken about the core principles that govern my approach to financial planning. So in today's post I will be speaking about those principles. I hope it offers a few insights into the way I think as a financial planner.
Prepare For The Worst Case Scenario
Financial planning is, first and foremost, aimed at managing risk. Of course, a sustainable return and achieving financial goals are definitely important. But we first need to put ourselves in a position to enjoy those returns and achieve those goals. And the most reliable way to do this is to manage risk effectively. A large part of my job is therefore to prepare for the widest range of outcomes possible.
The probability distribution for the range of outcomes to an event takes the form of a bell shaped curve. Positive and negative outcomes fall on the right and left sides of the curve respectively. The left end of the curve represents negative events that are highly improbable to occur, but are severely damaging if they do. These are called negative tail events. Examples of such events include the death of an earning member in the family, an exorbitant medical bill, permanent disability and so on. Negative tail events occur a lot more frequently in the financial markets and real life relative to what is represented on a standard bell shaped curve.
Such events can completely derail the financial stability and security of a family. It therefore becomes vitally important to provide for them. I therefore give utmost importance to guarding against the risks associated with such events. An adequately sized emergency fund, life insurance coverage and health insurance coverage are extremely effective against most such risks. I therefore believe that investing for goals should wait until all three of these are in place.
Focus On Answering Big Picture Questions First
An individual's overall financial health matters more than portfolio performance. I therefore focus primarily on answering pervasive money management questions relevant to a client's case. These include the definition of goals and associated risks, assessing monthly savings rates, asset allocation as well as guidelines for portfolio rebalancing and derisking. Portfolio performance and returns would typically take care of themselves once these aspects have been appropriately addressed.
Use The Simplest Solutions Available
Any given problem in personal finance has a set of solutions available. Some of these are simple while others are more complex. Complex approaches divert attention from the issues that really matter. This does not allow those following the plan to achieve the results they aim for from their financial plans. Of course, a complex solution typically sounds intelligent and provides intellectual stimulation. But such solutions are typically hard to understand and follow consistently. A given solution may be the most well designed one centred around the 'best' strategy. But it would be of absolutely no use if it cannot be understood by the people who are expected to implement it.
Simple solutions on the other hand allow one to focus on what really needs to be done. This automatically makes the process easier to follow and a lot more result oriented. It significantly improves one's chances of enjoying the desired results from their financial plans. This also aligns with a popular mental model for decision making known as Occham's Razor.
The model is typically applied when there are multiple solutions available to a problem. In all such cases, the simplest solution often ends up being the most effective one. The reference to a razor in the name of this model figuratively implies shaving away unnecessary assumptions and explanations.
Build A Simple But Purposeful Financial Structure
This is essentially an extension of the previous principle. I firmly believe that a simple financial structure designed with purpose is the better bet for most individuals. A simple but purposeful financial structure implies one that is easy to understand but built with clarity. Every element of the financial structure must serve a clear purpose. This effectively keeps the number of elements in structure to a minimum. It also means that investment portfolios would be designed with a few easy to understand products. This would help the individual for whom the structure is built to comprehend it easily. It is also likely to enable the individual to take charge of their finances a lot more effectively.
Doing this offers another important benefit. In every family, some members are usually more financially savvy than the others. It is these members who tend to take charge of the household’s money matters. Financially savvy members tend to put complex financial structures in place. They typically justify doing this by saying they can understand the structure and manage it effectively.
But it is important to note that a household’s financial structure is meant to serve everyone in the family. A simple financial structure is likely to outlive any single member of the family. This typically makes money management more accessible and understandable for everyone in the family. This means any member of the family can step in to manage money for the household if or when required. And the one in charge of money management is likely to do as good a job as any other member in the family.
Control The Controllables
The process of investing has a number of variables to it. These are :
How much we earn
How much we spend
How much we save and invest
How effectively we construct and manage portfolios (asset allocation, product selection, portfolio rebalancing and derisking)
Portfolio returns
We generally enjoy varying degrees of control over the first 4 of these variables. But we have no control over portfolio returns. And yet, returns are one variable that most of us typically focus the most on. This usually represents suboptimal use of our time and effort. It would therefore be prudent for us to focus on controlling the first four variables to the degree possible. The uncontrollable variable (returns) is likely to take care of itself over time.
Parting Thoughts
I hope the tenets expounded above offer an insight into the approach I follow as a planner. I have always preferred prudence, responsibility and pragmatism over popularity or sensationalism. And this what I have always tried to mould into my approach. A word of caution to readers before I finish. This post has been written purely for educational purposes only. No part of this article should be construed as being promotional or aimed at solicitation.
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