Predicting the Unpredictable in Your Finances

Predicting the Unpredictable in Your Finances

I’m conditioned by my profession to be responsible with my finances – sometimes excessively responsible – and I need to remind myself to have some fun! Luckily my outlet of choice is recreational softball where I’ve won a number of championships without risking any (major) money. However, I’m a big fan of Monte Carlo – that is, Monte Carlo simulations. These are invaluable exercises in helping you to assess some of the most important factors that will impact your financial future – those factors that you’re unable to predict.

Planning exercises compel us to think deeper about the future, something we don’t always excel at as humans conditioned to respond to the passions of our present moment. When I sit down with my clients to map out what the years and decades look like, they bring different aspirations and hopes, but do share one constant – they don’t want to be in the exact same place in a decade. They hope to feel wealthier, happier. They want to ensure their ability to make an impact in their profession or for a particular cause. They hope to have carved out more freedom for their time, more memories with their loved ones.

Time will inevitably bring change, and financial planning helps bring as much order to that process of change as one can expect. It helps provide a road map for how to get to arrive at your goals. What we cannot do, however, is fully account for the impact of the unpredictable. We can calculate the potential growth of your portfolio based on your projected earnings and historic rates of return; we won’t get it exactly right, but we have a pretty good sense of where the boundaries are.

What we can’t do is account for all of the pitfalls that may pass your way in the meantime; we can’t account for – well, life. Family members fall ill. We may lose jobs or see businesses go under. That’s just on the personal side of the spectrum, to say nothing of the uncertainties about the world beyond our own lives – the recessions and wars, the market down-turns and industry disruptions.

Take for example, the impact of a recent sequester on one of our clients who owns a defense contracting business. As a result of the uncertainty for specific contracts, he was forced to finance his business himself or encumber the company with additional debt (not a great scenario considering he was hoping to sell the company in 3 years). Analyzing his options required extensive analysis into his business and personal finances.

Clearly, we should approach the business of prognosticating about the future with a degree of humility. As the proverb goes – if you want to make God laugh, tell him your plans.

Planning for the Unplannable

When working with a wealth manager, make sure they have a strategy in place for accounting for life’s unknown variables. A lot can happen in time; your financial planning should resemble a GPS system that moves with you and can recalculate your route when you are off course. Especially proactive teams will seek to identify potential issues long before they emerge.

That’s where Monte Carlo simulations enter the picture – computer algorithms that calculate expected returns and volatility over a lifetime. This process differs from traditional mapping exercises by integrating chance and random outcomes (much like gambling in Monaco). These simulations will put your plan through the paces of thousands of simulated trials, factoring in a range of potential scenarios. What happens to your portfolio if we undergo a repeat of the 2008 crash? What happens in the event of stagnation?

You may have set a goal to average returns of 6% over the following two decades, but the future never unfolds exactly as planned. The markets rise and fall on forces we can’t predict; some years you may be up 20% and feeling like a Master of the Universe. Other years, you’ll be down 10% and ready to hold a yard sale to stay afloat. A Monte Carlo simulation studies the potential of all of these variations by assessing the standard deviations in each of your asset classes and randomizing returns to account for the deviation. So instead of just seeing what steady returns of 6% will do for your portfolio, you’ll see how often your portfolio hits your targets with all possible rates of return randomized.

While this tool may not offer value to all investors, we all can benefit from preparing for the unexpected. Chance is a big part of life. While we can’t predict the future with certainty, we can use the tools at our disposal to reduce our uncertainty and steady ourselves for all of tomorrow’s possibilities.

Whether you have a change in health or business your financial plan can help identify the means and methods to maintain your lifestyle during transition. Gaining peace of mind about your finances provides clarity in thinking so you can focus on what’s most important in your life.

To learn more, reach out today.