Financial planners, business managers, scientists and others build models of their environment. What are they looking for? Why bother?
Although not all people believe it, one thing is clear. No model provides a complete representation of reality. People make serious policy mistakes when they think models provide answers. They are too limited.
People build models looking for insight into process. Sometimes a dynamic model can demonstrate previously unseen relationships. Personal financial planning models often demonstrate that retired persons have more money that they will need. A model may give them comfort that transferring money to children earlier is possible.
Sometimes the model can show that the chosen course of action is likely to fail.
The most common error is to assume yield will be substantially higher than inflation. 4% better is very difficult to achieve over a long time. Income taxes are another serious impediment to success. If you earn 6% with a 40% tax rate, you keep 3.6%. If inflation is 3% there is very little real growth. All spending is real. Pay attention.
Models can create a shell of potential outcomes within which you may be safe. Projected spending with projected tax at some rate, income at another and inflation at another still combine for a result. There will be combinations of values where the plan is safe enough and others that demonstrate risk. A model that generates this sort of information is useful because it can serve as a template. People can compare actual outcomes and if the values are beginning to drift toward the unsustainable, earlier action is possible.
People should use models only for insight. They will not predict the future. Here’s why:
Use models to create ideas of what will work and what will not. The key variables to know are:
Models are soothing, but just because one seems to work does not mean you can stop paying attention.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772