Why Do Financial Plans Fail?

You have likely heard of Financial Planning, and you may even be using it yourself to prepare for retirement. Although it has become a very popular way to create portfolios, I have come to believe that traditional Financial Planning has four specific flaws that may be fatal. Since realizing how risky Financial Planning was, I have begun creating portfolios which have a higher return and create a margin of safety (or a substantial windfall of extra savings above and beyond what is nominally necessary for comfortable retirement) to mitigate what I believe are significant risks as the market changes with new technology and industries.

Our view is that traditional Financial Planning has the following flaws:

  • Plans do not adequately provide a margin of safety for black swans. Plans use averages which work well during normal times but are not geared to deliver a margin of safety for times like the Great Recession of 2007-2009 or the high inflation times of the 1970s.
  • Plans use probability models which are not reflective of actual market probability. Probabilities are calculated using the Monte Carlo Simulation based on the “Normal distribution” (the bell-shaped curve). Stock and bond market annual returns are skewed (weighted) unevenly around the average. Whether using the Normal Distribution or the so-called “Fat-tailed” distributions, neither reflects adequately the realized annual returns.
  • Plans are designed with asset allocation which may reduce volatility in the short-term but at the expense of longer-term margins of safety. As a hypothetical example, let’s use simple math: if stocks average 9% per year, bonds 5%, and cash 1%, and if the asset allocation is 1/3 to each of those asset classes, the average return is 5% (9+5+1=15, 15/3=5). While that may lower the volatility in the short-term, it comes at the expense of longer–term margin of safety.
  • Plans do not often consider increasing longevity and the changes in the living expenses that will come with longer lives.

Adams Financial Concepts does “Future Planning” as opposed to traditional “Financial Planning”. We believe that the flaws with financial planning outlined above can have a significant detrimental impact on returns, holding clients back from their objectives, given their risk tolerances.  We believe that the Future Planning AFC provides has a higher probability of delivering a margin of safety over and above traditional Financial Planning.

Our Future Planning focuses on building a portfolio of assets with a margin of safety, anticipating unknown factors such as negative black swans, to ensure that our clients’ future income needs are still met regardless of inflation or recession. To that end our plans are based on the following:  

  • Plans are designed to have a margin of safety that can withstand negative black swans. The key here is the margin of safety, using higher returns now to create a windfall between 25-50% above your suggested need with normal market conditions.
  • Plans are based on and updated using Bayes Theorem: We expect probabilities will change from year-to-year and portfolios need to be adjusted based on new conditions.
  • Plans are established using domestic stocks and bonds and are essentially fully invested. We believe that, although asset allocation may decrease short-term volatility, higher returns will result in a higher margin of safety over the longer-term. That is to say, the difference between 5% and 9% growth over 20 years on a portfolio beginning at $100,000 will be $265,320 versus $560,441. This adds a margin of safety of almost $300,000. (We recognize that past performance is no guarantee of future performance; therefore, we monitor on a regular basis).
  • Plans are, if possible, designed to generate income during retirement or pre-retirement as needed without dipping into principal, so changes in life expectancy and the cost of that added life will be covered by regular income withdrawals.

Traditional financial planning takes a person’s current financial situation, applies an asset allocation, and projects the future using averages for the different asset classes. Then, using Monte Carlo Simulation (which is based on incorrect statistical assumptions), they estimate the probability of meeting future needs. During the 2007-2009 Great Recession, this methodology failed a number of people.[1][2][3][4]

Future Planning recognizes that relying on averages does not address the issue. We understand a lot can go wrong. Consider this analogy provided by Annie Duke in her book Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts:

“Operation Overlord, the Allied forces operation to retake German-occupied France starting in Normandy, was the largest seaborne invasion in military history. It involved planning and logistics on an unprecedented scale. What if the forces were delayed at the start by bad weather? What if the airborne landing force had trouble communicating by radio due to the terrain? What if significant numbers of paratroopers were blown off course? What if currents interfered with the beach landings? What if the forces on the different beaches remained separated? Countless things could go wrong, with tens of thousands of lives at stake and, potentially, the outcome of the war. 

All those things did go wrong, along with many other challenges encountered on D-Day and immediately thereafter. The Normandy landings still succeeded, though, because they prepared for as many potential scenarios as possible… (emphasis added)

“All methods of imagining the future are not created equal.”[5]

When we use Future Planning, we anticipate that there are a lot of things that can go wrong. There will be black swans like the Great Recession or political or geographical instability. There can be a bout of very high inflation or unfair competitive tariffs and shutdowns. We will prepare for all the potential setbacks to investments that we can imagine, but black swans are those happenings that could not be imagined. We need to have a sufficient margin of safety that we can help our clients even survive those.

Think about Operation Overlord: innumerable things could have gone wrong and many did. Had they taken the standard financial planning approach of assessing the troops and equipment, applied average battle results, and then estimated the probability of success, World War II would probably have turned out very differently.

Because they prepared for the worst, they succeeded. That is what we hope we do with building a margin of safety in our Future Planning.

[1] Scott Mayerowitz and The Associated Press, “The Personal Stories Behind Wall Street’s Crash and Revival,” The Mercury News, August 12, 2016, https://www.mercurynews.com/2013/03/05/the-personal-stories-behind-wall-streets-crash-and-revival/

[2] Vanessa Wong, “Here’s How Millennials’ Lives Were Changed By Recession 10 Years Ago,” BuzzFeed News, September 25, 2018, https://www.buzzfeednews.com/article/venessawong/millennials-lives-changed-by-recession-2008-2018

[3] “Boomers and the Great Recession: Struggling to Recover,” AARP Public Policy Institute, https://www.aarp.org/content/dam/aarp/research/public_policy_institute/econ_sec/2012/boomers-and-the-great-recession-struggling-to-recover-v2-AARP-ppi-econ-sec.pdf

[4] Emily Brandon, “10 Ways the Recession Has Changed Retirement,” U.S. News, May 27, 2018, https://money.usnews.com/money/blogs/planning-to-retire/2011/05/27/10-ways-the-recession-has-changed-retirement

[5] Duke, Annie, Thinking in Bets (Penguin, 2018).

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