Financial Plans Are A Bit Like Battle Plans

My friend Michael Kitces has a great post about the limitations of financial planning tools, particularly when it come to… wait for it…. formulating a real financial plan! That article is so good, you really ought to quit reading this one and head over to there right now. Go!

I particularly like Michael’s analogy;

In the military context, battle plans are recognized as essential. And this is true despite the famous saying that “no battle plan ever survives contact with the enemy” because the process of engaging the plan, progressing towards the goals, and seeing what happens once the enemy is engaged, will itself change and alter what the next step should be. Notwithstanding this challenge, the military engages in planning because it’s only by trying to consider what the plan should be, and how it might be impacted by future events, that contingency plans can be created to know how to handle “unexpected” problems that arise.

He also notes that…

For instance, traditional financial planning once modeled the future by simply projecting how the plan would fare given average returns. Of course, the caveat is that while the future might involve getting average returns (or a sequence of returns close enough to approximate that result), there are other future scenarios that might involve lower returns (or a worse sequence of returns) as well. Accordingly, financial planners shifted to using Monte Carlo, so that we can quantify how often the future scenarios are likely to turn out to be problematic. We might run 10,000 future scenarios, find that 9,500 of them succeed and 500 of them fall short, and quantify the results as a “95% probability of success” in achieving the goal.  Yet as previously discussed on this blog, rarely does anyone in “the other 5%” of scenarios actually just keep on spending under the original plan until one day he/she wakes up broke and all the checks are bouncing. Instead, at some point, an adjustment occurs to get back on track. Of course, the later the adjustment occurs, the more significant it may have to be in order to get back on track. But ultimately, most probabilities of “failure” are really just probabilities of needing to make an adjustment to get back on track.

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The point Micheal makes rather brilliantly is that planning requires us to consider and explore what sorts of scenarios could potentially cause a financial plan to fail or more precisely, require an adjustment to the plan. But we need to go beyond this, the real value is to then formulate an action plan, in advance.

Straight line, deterministic cashflow projection is still very much the common practice here in the UK. Planners often ask me the value of Monte Carlo or probabilistic models, and in particular, the value of considering the probability of success or failure of a plan. One planner recently emailed me asking; My problem with …say 75% chance of success or failure, is that people don’t understand it. So the question, is it really helpful for clients or of more interest to advisers? 

My answer would be; looking at probability of success/failure is both of value to client and the planner. It helps us consider what kind of market or economic conditions could derail a client’s plan and more importantly, to agree with the client, in advance, what exactly are we going to do when those market conditions show up. We are able to give clients confidence that they are going to be OK, under most circumstances and reassure them that we know exactly what to do in other less favorable circumstances.  In effect, we are saying to the client, in x out 100 potential scenarios, you are going to be on track to meet your goals, but there are certain market conditions such as this and this and that which will require us to make adjustments. If and when those nasty market conditions show up, this and that and that is what we are going to do.

[bctt tweet=”Monte Carlo models help us consider what kind of market conditions could derail a client’s financial plan.” via=”no”]

And if we agree this in advance with the client, chances are they are far less likely to  panic when craps hits the fan. When they walk back into out office after a serious market decline, we are able to tell them if this is the kind of market condition that could derail their plan, because we’ve tested it and more importantly, implement the agreed corrective measures.

As advisors, we are trained to always tell clients to “stay the course” and stay invested and ride out the volatility… which both fails to fully acknowledge client fears, and more substantively fails to clarify for clients the difference between “temporary” volatility and a genuine impairment of their plan. In other words, “everyone” knows that at some point, a market decline is so severe that stay-the-course platitudes aren’t enough, and it will require adjustments to get back on track. What clients don’t know is the point at which those adjustments will be necessary, and how much of an adjustment will be necessary – in part because financial planning software gives us no tools to formulate and illustrate such a plan. Instead, the ‘point of no return’ threshold for the client is unknown. And that uncertainty is often exacerbated by the fact that clients tend to overestimate the significance of short-term volatility, and misjudge how little of an adjustment is usually necessary (if any!) to stay on track.


The point here is that it’s neither effective, nor helpful just to tell clients to stay they course; we must be able to show them when and what adjustments will be necessarily when crap its the fan!

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Abraham Okusanya
Abraham is the founder of FinalytiQ, a research consultancy for platforms, asset managers, and advisory firms. Recognised as one of the country’s leading experts in retirement income, platforms and investment propositions, Abraham has authored several papers on these subjects and delivered talks to the Personal Finance Society, The FCA and several conferences across the country.
He holds a Master’s degree from Coventry University and an alphabet soup of qualifications, including the Investment Management Certificate, Chartered Financial Planner, CFP and Chartered Wealth Manager designations. He was one of 5 finalists for the Professional Advisers Personality of Year Award 2015 but the award went to a more deserving winner, obviously!

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