The Illusion Of Precision In Financial Planning

Financial planning is a vitally important exercise. It adds value to most people. Yet it is often criticised for two main reasons. These are reflected in the following questions I often get from clients :

1. How can we be sure that the assumptions we are using in my plan are correct?

2. You say that my plan cannot guarantee the achievement of my goals. So what is the point of planning?

The first question reflects skepticism over the accuracy of assumptions used for financial planning. The second highlights uncertainty of future outcomes. These questions are perfectly natural. Human beings crave certainty and accuracy when operating in uncertain environments. And life is nothing if not uncertain. But this does not change the fact that it is unfair to seek certainty and precision from a financial planning exercise. And I will show why this is the case in today's post.

Blanket Financial Planning Assumptions Are A Myth

I welcome my clients' skepticism about the veracity of blanket financial planning assumptions. In fact I wholeheartedly agree with it. This is not so much because of the figures that are assumed. It is more because of the implications behind the assumptions. Blanket financial planning assumptions are static. They remain constant over long periods of time. Such assumptions imply linear increases in the variables they affect over time. Assuming an inflation rate implies that expenses increase uniformly over time. Assuming a CAGR return from the portfolio implies that the portfolio grows at a fixed rate over time. Assuming a particular life expectancy implies that an individual would live for a fixed number of years.

But this is not how things work in the real world. Expenses and spending patterns vary from year to year. There are a few cases where expenses drop from one year to the next. Therefore assuming a linear increase in expenses at a fixed rate is mostly unrealistic. A CAGR return essentially ignores volatility in returns. This makes no sense for any portfolio that includes market linked products. And almost all portfolios do include them. There is also no way to precisely forecast how long one would live for.

The use of blanket financial planning assumptions must therefore be minimised as much as possible. The best way to do this is to plan for zero real returns. The zero real returns approach implies that post tax portfolio returns are cancelled out by inflation over our lifetime. It considers actual expenses year on year. This negates the need to assume an inflation rate. More on the concept of zero real returns can be found in my earlier article Zero Real Returns : Seemingly Zero Logic, Definitely Very Real.

Goal planning calculations must be done afresh every year taking actual portfolio values. The actual value of the portfolio must be be subtracted from the target corpus required for the goal. The objective would then be to reduce the gap between the value of the portfolio and the target corpus. The gap must ideally be covered by time the goal falls due. Doing goal planning calculations this way negates the need to assume a rate of return from the portfolio. This method is covered in more detail in my earlier article Why CAGR And Market Linked Investments Don't Go Together.

Blanket financial planning assumptions advertise precision but don't deliver it. Our assumptions and inputs must be in line with our prevailing life circumstances. As circumstances change, so must our assumptions and inputs. This would eliminate the need to test the veracity of financial planning assumptions. It ensures that our assumptions retain relevance and realism. The essence of this fact is encapsulated in the below quote from Bruce Lee.

Even The 'Best' Financial Plan Cannot Guarantee Success

Firstly, there is no such thing called the 'best' financial plan. But for the sake of this discussion let us assume that such a plan exists. A plan that accounts for the widest range of possible outcomes. A plan that is easy to understand follow. A plan where the assumptions used have been back tested under a wide range of scenarios. But it still cannot guarantee the achievement of the outcomes we desire. This is because a financial plan is not a silver bullet that we use to achieve our goals.

It is simply a road map for the future based on past circumstances and present requirements. It is prepared with the knowledge available at a particular point of time. But this does not change the fact that we have no control over future events and outcomes. Financial plans can therefore never remain static. Constant course correction would be required when circumstances or requirements change. This is true regardless of the quality of the plan. This helps keep the plan relevant to requirements. This leads to one big million dollar question.

So... Why Bother Planning?

This question is asked because the wrong expectations are set from financial plans. Most people expect financial plans to be a silver bullet that guarantees the achievement of their goals. But financial planning and plans derived therefrom are never outcome centric. They are always process centric. They put in place a clear structure and framework to follow when managing our money.

This provides better clarity when circumstances become uncertain. Constant adherence to the structure and framework set by our financial plans is what matters most. A reasonable chance of achieving our goals is simply a natural consequence of this. The actual value add from financial planning is therefore not in the delivery of outcomes. It is in the clarity and peace of mind it provides.

Concluding Thoughts

The illusion of precision in financial planning is mainly born from erroneous perceptions. It exists because financial planning is often viewed as a one time exercise with a definite end point. But it is anything but that. Financial planning is a continuous process that gets improved upon over time. An individual's financial plan represents the codification and quantification of their financial position. The financial plan always pertains to a particular point of time rather than a period of time.

It can provide clarity on the next step of the journey. It can never guarantee that we reach our destination. Achieving desired outcomes with our money is simply a consequence of sticking to our plan over time. Viewing financial planning in this light requires a lot of maturity. Not everyone would possess it. But everyone can develop it. And once they do, they would be able to see through the illusion of precision in financial planning.