The Value of Modeling
In the early stages of the COVID-19 epidemic, models were introduced to help us solve our huge problem. The focus of these models was on the potential impact of “flattening the curve” of cases in the United States, if we took (or did not take) certain actions. Based on what the models revealed, many American changed some of their behaviors—immediately. For most of the country, these behavioral changes have resulted in a more positive outcome than was experienced in other parts of the world.
We observe similar benefits from behavioral changes with financial modeling. We always use modeling when we prepare a financial plan. We start with your Base Case, also known as your “current course of action.” That “model” shows when and if you are ready for retirement, and how long your funds are likely to last — if you make no changes to your current financial behavior (including your spending patterns.
One of our clients, who is an academic professor, uses this signature line on his emails: All models are wrong but some are useful. GEORGE E. P. BOX. Evaluated in retrospect, all models are inherently flawed because the future they project never follows an exact pattern. Nevertheless, we use models, attempting to replicate your future behavior patterns, as closely as possible.
Yet in spite of our best efforts, the models will never be exact replicas of your financial behaviors. First, we sometimes receive spending patterns that are generalized guesses. If the patterns that we use for modelling do not correlate with real, measured spending, there is a greater likelihood that the models will provide inaccurate answers. This has been one of the huge benefits of PlanFirst! It gives you the ability to both accurately and painlessly, capture your real spending patterns. This information vastly improves the quality of our modelling.
Second, we model portfolio rates of return on a straight-line basis, except when we employ a technique like Monte Carlo Simulation or other scenario analysis. Even if we are using a conservative rate of return, we are projecting that you are consistently earning this same rate of return for 30-40 years. Real life does not happen in straight lines.
Third, we assume that your current pattern of spending will remain the same, except for known future changes. For example, we will use your best estimate of when your children will become financially independent, or we will include increased medical costs in retirement, etc. Contrary to many retirement experts, our experience has been that clients spend slightly more in the initial phase of retirement than they do during their working years. Then, things become tricky because there is an inevitable slowdown in activity at some point in the later period of retirement. We tend to be conservative and assume that slow down happens in the later years of retirement.
After adjusting for rates of inflation, auto purchases and other major expenses, we let models speak for themselves. Some people are shocked when they see the results. Yet, the surprise can cut both ways. On one hand, the models can indicate your assets will be depleted in the early stages of retirement. In other cases, the opposite happens. If the models illustrate that you will likely die with millions (we generally use age 100), you realize perhaps you can loosen up and spend a bit more. The value of modeling is to help you to shape your behavior TODAY, once you see what might happen tomorrow.
An even greater benefit to modeling is to determine whether there might be one controllable variable that could blow up your future hopes and dreams. While this key variable could be your general lifestyle, it is often a single, big financial or lifestyle decision. For example, we have seen several cases where a “retirement dream home” was jeopardizing the couple’s retirement. Models help us see the impact of possible solutions: For example, modelling may show that moving to a smaller, less expensive home that your retirement savings could last 10 years longer. Other examples of key financial behaviors might be:
• Taking to that one less vacation per year,
• Working for two additional years,
• Selling a vacation home that has larger upkeep costs than you realized,
• Trading cars in less frequently.
With the use of models to shape behavior, you have “magically” added years to your retirement nest egg. It is generally not the stock market or economy that dictates your success or failure in retirement. Instead, it is the day-to-day choices of the household.
While it is tempting to debate and focus on what is happening “out there” at this moment, we recommend reflecting on the changes you can make now to improve your personal situation down the road. Positive changes now, even with all of the uncertainty, will greatly increase the odds of a much brighter future when this pandemic is over.
Kristina Bolhouse CPA/PFS, CFP®
Copyright © 2020 The Arkansas Financial Group, Inc., All rights reserved.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by The Arkansas Financial Group, Inc.-“AFG”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from AFG.
Please remember that if you are a AFG client, it remains your responsibility to advise AFG, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. AFG is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the AFG’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request.
Please Note: AFG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to AFG’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.