You can’t always be right, but having a strong plan and constantly evaluating where you are can help you change course when bad things happen.
Most people don’t know how to accurately figure out odds and risks when planning their finances. So, if something goes wrong, their plan for their money is likely to fall apart. Which means it almost always falls apart, because there are a million things that happen in life that we can’t predict, didn’t plan for, or just forgot to think about.
Planning is not a waste of time. It’s that we need to think of planning as a process, not as something we do once and then forget about. We also need ways to make stronger financial plans that can stand up to the bad luck, bad decisions, and wrong assumptions that are bound to happen along the way.
You don’t have to know what will happen next to make a better plan. At our company that helps people plan their finances, we don’t try to be right all the time. Instead, our goal is to treat risk with the respect it deserves, both in investments and in life, and to make strong financial plans that take into account how probability really works. Here’s what you should do.
1. Don’t let yourself feel too safe
Even people who are good at math have a hard time figuring out how to apply probability to real-life situations. After the 2016 election, when people were shocked that Donald Trump won, this was very clear. The best pollsters said that he had about a 30% chance of being elected. “Not as likely” is not the same as “impossible.”
Most people think that a low chance of success means there is no chance of success, but there is a huge difference between a 30% chance of something happening and a 0% chance.
So, if you want to make a better financial plan, you can’t just use models that give you a “probability of success” as if it were the only thing that matters. Monte Carlo simulations can be very helpful, but they can also lead people astray in a big way. This is especially true when you’re younger and have more time for things to turn out differently than you thought they would.
Don’t think you’re good to go just because a math formula says you have a 70% chance of success. It’s a good sign that you’re on the right track, but if you want to make a good plan, you need to keep reevaluating as time goes on and remember that likely is not the same as guaranteed or risk-free.
2. Carefully think about your assumptions and pick actions you can stick with.
By not making aggressive assumptions, planning can take into account the chance that a downside risk will happen. I love this quote by CFP, author, and speaker Carl Richards, which I’ve paraphrased: “Risk is what you find out about after you think you’ve thought of everything.”
This means that the one thing you forgot to plan for is the thing that’s most likely to come up and throw you off! Still, you can’t possibly predict everything that will happen. You can make assumptions that are reasonable and don’t depend on everything going your way. Planning “conservatively” isn’t always the answer. You can make a plan that can’t fail if you plan (opens in new tab) consistently.
For example, if you’re in your 40s and at the top of your career and earning years, you might expect your fast-growing salary to keep going up over time. You might expect 5% to 7% annual increases because that’s what you’ve seen in the past few years.
This might not work for another 10, 15, or 20 years, though. If you use that assumption and your income growth slows or drops, your plan might not work. So, instead of making a bold assumption, we could just assume that income will grow by a smaller amount over time, like 2.5%.
You don’t have to always think of the worst that could happen… But you can’t always hope for the best either. If you change what you think will happen, you can make a plan that will work no matter what.
Here’s a quick list of some of the things that a plan is based on:
- Pay and how long you think it will take you to work or make a certain amount.
- Living costs now and when you retire.
- Returns on investments and how long you plan to invest for.
- Goals, their costs, and when they need to be done.
Depending on the variable, you may want to either under- or over-estimate what you expect (like with income and investment returns) (as with expenses or inflation).
3. Don’t forget that life goes on outside of spreadsheets.
Any plan for your money is only as good as the data you put into it. On paper, you can make a lot of things work. If you know how to use spreadsheets, you can get the numbers to tell you what you want to hear. But spreadsheets don’t show how your day-to-day life works.
The quality of that time is important because that’s how you actually live your life: as your present self, in the short term. In the meantime, your financial plan requires you to make decisions that will help you in the long run. You don’t know anything about that “self.”
A good plan takes this into account and tries to find a balance between enjoying life now and making plans for the future.
4. Don’t count on one thing to make you successful.
Be careful about how much weight you give to any one factor in your plan. Use reasonable assumptions instead of ones that are too aggressive or too optimistic. Diversify instead of putting all your eggs in one basket, just like you would with your investments.
When clients try to rely too much on one variable, we often see these situations:
- Depend on big bonuses, commissions, or on-target earnings all the time.
- Expecting to get consistent equity compensation over time through refresher grants, which aren’t actually guaranteed.
- Using what a pension is expected to be worth 20 years from now (and not considering what happens with a career change).
- Waiting for an initial public offering (IPO), which may not happen, and a high share price, which can change.
It might be fine to plan for these for the next year or two, but counting on them for the next 10, 20, or 30 years is a sure way to fail.
If you think that bonuses, commissions, or earnings on target will add up to 100% of your salary, you should plan for 50%. If you have a pension, you can estimate your retirement income by comparing the amount of pension you are guaranteed to get today to the amount of pension you would get if you worked at the company for another 20 years.
If you get RSUs today, you should count them, but you shouldn’t plan for more grants in the next five years. If you’re hoping for an IPO, don’t! You have no control over that, and you can’t build a whole financial plan around the idea that (a) your company will have an IPO and (b) you’ll make a lot of money if it does.
5. Give Reasons for Change
Plans that are likely to work include a natural buffer for when things change in life. These changes could be outside of your control, like economic downturns that cause companies to lay off workers or pandemics or other natural disasters that stop economic growth (and, therefore, your investment returns).
You might be able to change other things, which isn’t always a bad thing. You could just change your mind about your job, where you live, or what you want to achieve. Changes in your personal or family life can happen out of the blue and throw a major wrench in your financial plan.
When my wife and I decided to have kids, we learned this the hard way. We were on the fence for years (and even leaning toward being child-free by choice). Our financial plan was based on our current situation. We didn’t have a goal to save for college, and we didn’t think about how much more money we’d need to cover the costs of a bigger family.
We did, however, build some extra space into our plan. Our specific plan was to set a “retirement” goal that was very ambitious. We planned as if we would stop getting money when I turned 50. I didn’t really want to retire this soon. I love my job and my business, so I didn’t think that all of our income would suddenly stop and we’d have to start living off of our investments.
But for that version of the plan to work, we had to save a lot of money, even though we didn’t think it was likely that we’d retire so soon. We were able to make a change when we decided to have kids because we had saved so much for so long.
We changed the plan by putting off retirement and lowering the rate at which we save money now. We could afford to move because we had saved so much over many years. When we slowed down our savings rate, we had more money to pay for a new baby (as well as to fund new priorities, like college savings).
Without the right amount of wiggle room in the plan, it will break or even fail in a way that makes it hard to get back on track. When we plan, we want to make sure this doesn’t happen.
Change isn’t always bad, but it’s almost always going to happen in some way or another. A good financial plan lets you change direction without making you give up what you value most.