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Most people do not know how to accurately assess probabilities and evaluate risk in their financial planning. As a result, their financial plan is likely to fall apart the moment something goes wrong. Which means it almost always falls apart, because there are a million things that happen in life that we can’t predict, didn’t account for or simply forgot to consider.
It’s not that planning is pointless. 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 for building 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 build a better plan. At our financial planning firm, we’re not trying to be right all the time. Instead, our goal is to give risk — in investments and in life — the respect it deserves and build strong financial plans that recognize how probability actually works. Here’s how you can do the same.
1. Avoid False Senses of Security
The average person (and even those who are mathematically inclined) tends to struggle to apply probability to real-life scenarios. We saw that 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) of a positive outcome. “Not as probable” doesn’t mean “impossible.”
Most people equate a lower probability of success to no probability of success, but a 30% chance of something happening is very, very different than a zero percent chance.
To build a stronger financial plan, then, you cannot rely on models that give you a “probability of success” as the end-all, be-all stamp of approval. Monte Carlo simulations are very helpful, but they can also be incredibly misleading. This is especially true the younger you are, when there’s more time for variables to play out in different ways than you’ve assumed.
Avoid looking at situations that a math formula tells you have a 70% likelihood of success and thinking you’re all set. It’s certainly a good indicator that you’re on the right track, but building a strong plan requires you to continually reassess as time passes — and recognize that what’s probable is not the same thing as guaranteed or risk-free.
2. Consider Your Assumptions Carefully and Choose Actions You Can Stick With Consistently
Planning can account for the potential for downside risk to show up 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.
Meaning, that one thing you forgot to factor into the plan is the thing that is most likely to pop up and throw you for a loop! You can’t possibly account for every reality that will come to pass, though. What you can do is use reasonable assumptions that aren’t predicated on everything going your way. It’s not necessarily about planning “conservatively.” The way you build a foolproof financial plan is by planning (opens in new tab)consistently.
For example, if you’re in your 40s and at the peak of your career and earning years, you might expect your fast-growing salary to continue to increase over time. Perhaps you expect to see 5% to 7% increases every year (because that’s what you’ve seen over the past few).
That may not be sustainable for 10, 15 or 20 more years, though. If you use that assumption and your income growth slows or drops, then your plan might not work. So instead of using an aggressive assumption, we could simply assume a smaller growth in income over time (such as 2.5%).
You don’t need to assume a worst-case scenario at every turn… but you can’t assume the best with every 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 a plan:
- Earnings and how long you expect to work or make a certain salary.
- Living expenses now and in retirement.
- Investment returns and your investing time horizon.
- Specific goals and their costs and timelines.
Depending on the variable, you might 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 of Spreadsheets
Any financial plan is only as good as the information you plug into it. You can make a lot of scenarios work 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 everyday life.
The quality of that time matters, because that’s how you actually experience your life: as your present self, in the short-term. Meanwhile, your financial plan requires you to make long-term decisions for the benefit of your future self. That’s a “self” you don’t know at all.
A strong plan recognizes that friction and aims to find the balance between enjoying life today and planning responsibly for tomorrow.
4. Don’t Depend on a Single Factor to Get You to Success
Along with using reasonable rather than aggressive or overly optimistic assumptions, be careful about how much weight you put on any one factor in your plan. It’s just like your investment portfolio: Diversify rather than put all your eggs in one basket!
These scenarios are common when we see clients trying to over-rely on a single variable:
- Continually relying on large bonuses, commissions or on-target earnings.
- Expecting to receive equity compensation consistently over time via refresher grants (that aren’t actually guaranteed).
- Using a projected pension payout 20 years from now (and not considering what happens with a career change).
- Waiting for an IPO, which might not happen, and a high share price, which can fluctuate.
It might be OK to project these out for a year or two, but to rely on them for the next 10, 20 or 30 years is setting a plan up for failure.
If you expect bonuses, commissions or on-target earnings to add 100% to your salary, project 50%. If you have a pension, project your retirement income with the pension amount that you are guaranteed today vs. the projected pension income that would be received should you work another 20 years at the company.
If you get RSUs today, factor those in, but don’t project additional grants for the next five years. If you expect an IPO … don’t! That is completely out of your control, and you cannot build an entire financial plan on the assumption that (a) your company will have an IPO, and (b) you’ll profit handsomely if it does.
5. Account for Change
Plans that have a high likelihood of success build in a natural buffer (opens in new tab) for life changes. Those changes could be external in nature, which are out of your control, such as economic recessions that lead to company layoffs or pandemics or other natural disasters that shut down economic growth (and, therefore, your investment returns).
Other factors could be within your control, and these aren’t necessarily bad things. You could simply change your mind about your career, living situation or goals. Personal or family dynamics can shift in unpredictable ways 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 (and even leaning toward being child-free by choice). Our financial plan reflected our current reality; we didn’t have a “saving for college” goal or account for the generally higher cash flow we’d need to manage the expenses of a bigger family.
What we did do, however, was build buffer room into our plan. Our specific strategy was to set a very aggressive “retirement” goal; we planned as if we would stop receiving income when I turned 50. In reality, I didn’t want to retire this early. I love my work and my business, and assuming all our income would come to a screeching halt and we’d start living off our investments at that point was pretty unlikely.
But that version of the plan required a very big savings rate in order for it to work, which we stuck to even though we didn’t feel it was likely that we’d retire so young. That intense rate of savings for many years allowed us to pivot when we decided to have kids.
We adjusted the plan by pushing our retirement ages out and reducing our current savings rate. We could afford to make that move because we saved so much for many years previously, and reducing our savings rate freed up cash flow to manage the expenses of a new baby (as well as to fund new priorities, like college savings).
Without the proper buffer room in the plan, the plan breaks and maybe even fails in a way that doesn’t allow for an easy recovery. We want to avoid this failure when we plan.
The point is that change isn’t always bad, but it almost inevitably happens in some shape or form. A strong financial plan is one that allows for a pivot without forcing you to give up what’s most important to you.