For financial decisions, knowing beats guessing
“I’d rather be vaguely right than precisely wrong.” — Keynes
You’re considering a mortgage refi that will free up 100 bucks a month. You are in the process of purchasing some life insurance (finally) and wonder how much to buy. After all, you don’t want to be worth more dead than alive (a common and annoying phrase often heard in my line of work). You want to retire or go “work optional” at some point. Are you on track to have enough savings?
These are super-common questions that virtually everyone faces at one time or another, and many times people don’t really perform any kind of serious numerical analysis to find definitive answers. They do the best they can to figure it out on their own or ballpark it, based on their own knowledge and some semi-educated guessing. And the truth is, that’s not a bad approach for some questions.
For decisions that carry a significant impact on your financial future, though, it’s quite unwise. So the question becomes: When is the impact big enough to warrant the time and expense of consulting a subject matter expert? Over the years I have found that many people underestimate the importance of seemingly trivial financial choices like when to refinance a mortgage or figuring out how much term life insurance they need.
The answers may seem simple — and on the surface, perhaps they are. But what seems to be a straightforward choice can turn out to be a serious mistake if things don’t go quite the way you planned.
For example, how does the entire situation change if there is an extended bear market? What happens if you lose your job? Or say you’re paying for college, juggling cash flow through those years with current income plus a little savings in a 529 account…and it takes more years than you expected.
You’ll need to take some unplanned withdrawals from your retirement accounts. No problem, right? Maybe not at some points, but if the market happens to be down and you take the money out you’ll be years away from work-optional, and you really didn’t want to have to work well into your 70s. Oops!
The point is, you can’t anticipate everything that might happen — and you can definitely make yourself crazy trying. What you can do is run hundreds (or even thousands) of stress tests to establish the mathematical likelihood of encountering problems based on your decision to refi, go work-optional, put a certain amount in savings each month, commit to paying for college, take out a certain amount of life insurance and whatever else you might be considering.
Or rather, a good financial advisor can and should do this for you. Some do, but others might not. Advisors have multiple ways to get you answers, and some are more valuable than others.
Some financial services professionals sell products. Their answers may or may not be colored by a preference to implement a specific product to help you resolve the question.
Experienced advisors might give you their gut take on whether you can do it. Is their gut take any more valuable than yours? Frankly, yes, but it’s still not as solid as math. True financial planning should always include scenario testing under many conditions to inform decisions.
The reality is that you will need to pull money out of your accounts, but here’s the problem. We tend to assume a standard rate of return in the markets but that’s not how it actually performs. If markets grew at the same rate each year (heck, if anything was always the same each year) the future would be easy to predict and giving financial advice would be a simple matter. But markets vary, and so do jobs and new opportunities and kids and illness and death.
I frequently run cash flow scenarios “killing a spouse off” at age 45 to see the impact on current cash flow with current life insurance. I can then view probability of success to see if the surviving spouse can continue the existing lifestyle without running out of money. Similarly, I can see how using your company stock to pay for your kid’s MBA impacts your ability to you retire at 60.
Since we don’t know how the market will perform, or what will happen in your family or your career, mathematical Monte Carlo simulation is really key to understanding your probability of success given 1000 potential scenarios.
Gut calls and intuition are excellent tools to rely on for deciding between chicken and steak. When it comes to your financial world though, scenario stress-testing is critical.