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:
- No one understands how the world economy works in sufficient detail to code it into a model. Everything is an estimate.
- There usually is too little information available. People cannot know everything and sometimes the future will be so different from the present that any model based on the present will be wrong. In a personal model, suppose you became sick and cannot work, or you lose your job and can’t find another for a year. You can model those but no one does.
- the people who code the machines have biases. Not always intentional but there nonetheless.
- Finally no one does super high accuracy personal financial models because they have too little computer power. Managing more than a dozen or so variables is quite a challenge for the programs available on personal computers. In the real world there are hundreds, even thousands, of things to keep track of and by the time a personal computer solved the question, the world could well be different.
Use models to create ideas of what will work and what will not. The key variables to know are:
- How much must I save each month,
- What reasonable spread over inflation should I work with,
- How can I minimize taxation,
- What adverse events could happen in the future and how can I provide insurance or other alternatives to mitigate them.
- What metrics will I track to test the fit between my model and reality.
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. email@example.com 866-285-7772