I have been building computer models of financial situations and business plans for close to 40 years. There is just one thing I have learned in those 40 years. No model is correct.
Which leads to the question, “Why do some people behave as if modeled answers are facts?” There is another whole crowd who behave as if nothing is fact and apply some discounts to the numbers. Neither are right.
Models produce ideas about how things interact and what might happen, “all things being equal,” which they never are and seldom specified.
Systems are complex, not all the variables are known with precision and not all variables are weighted correctly. In financial modelling there is another factor. There are other people involved and their decisions will influence the outcomes. You cannot know how they will act in a given future circumstance once they see how you have acted. You cannot even know how you will react.
Any system that includes other people, “intelligent agents” is the correct term, is not capable of producing answers about the future. Models rely on global generalities for their variables and their rules, but people respond locally. People who lose their job behave differently than those who get promoted. Maybe it all averages out or maybe it does not. Maybe it averages out a year or two later.
Once upon a time, a 40 year personal financial plan was probably useful. In North America things fluctuated but, they did not change all that much. Not so true now.
In finance it is important to note that the global systems include many important variables that are not considered in most models. You can no longer be certain that the US Dollar will remain a dominant reserve currency. You cannot know how the industrialization of China will play out. You cannot know how Islamic ideas will end. What of Europe? Will Americans go back to their making money heritage or continue the getting money game of service and packaging? Who knows? Who knows if it will matter?
Modelling complex systems is to gain insight not to provide answers. For some local questions, models can show where the edges of the problem are. Should I pay down mortgage or invest in an RRSP? Is an RRSP better than a Tax Free Savings Account? Should volatile returns influence my decision to participate in a leveraged investment? In any of these questions, is there a rate corridor that works and others that do not?
Modelling allows you to think about questions better, but it will not provide answers.
Any model must be updated as new information and new relationships become evident. No plan is complete without a robust review and revise process. Be sure to consider how you will collect information and how you will assess its meaning.
It is like driving. You cannot know everything that will happen before you leave. It is those little steering wheel adjustments that keep you moving towards your goal
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Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.