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What does financial planning look like?

As I've mentioned earlier, there are several types of financial advisors in the world, only some of whom really focus on creating a holistic financial plan. But even financial planners can differ not only in terms of what they offer (do they cover insurance? estate planning? budgeting?), but also how they go about offering it. Below are some features of planning that may vary from advisor to advisor, so you can make sure you're getting what you need.

Monte Carlo Simulation v. Straight-Line Projections

Financial planning involves projecting into the future, so: how does the planner go about doing that? There are two major assumptions a planner can make.

A straight-line projection is pretty straightforward: let's assume your portfolio has, say, an 8% return year-on-year, and make our projections based on that exact number, every year, from now until the end of time. We could get fancy and assume a 5% "real" return, taking potential inflation into account (and some way or another you'd better be taking inflation into account!), but the outcome is the similar: you have the equivalent of an Excel spreadsheet that shows your net worth moving in a nice, smooth fashion over time:

Now, some of you may be thinking that this is total nonsense -- and you'd be half right. It's true that any portfolio with the slightest bit of risk is going to have ups and downs; it may have an average return of 8% (and we'll save the discussion of whether it's the arithmetic or geometric average for another day), but one year it may be down 5%, another up 21%, and so on. A market downturn at the wrong time -- say, right as you retire -- could blow up your financial plan, and a straight-line projection doesn't capture that at all.

That said, such projections are useful for estimating the dollar benefit of a given planning strategy versus another. For example, say you're considering making Roth conversions in retirement. This will cost you up-front, as you pay taxes on the conversions, but should benefit you in the long haul, as you end up paying less in taxes down the line (especially since you don't have to take as much in the way of RMD's, if anything at all!). But when's the crossover point? That is to say, how old are you before your projected net worth after doing the conversions surpasses what it would be if you didn't do them? If it's, say, age 92, then maybe you'll want to reconsider the conversion, given such a late payoff. (Or not -- that's a personal decision!) Straight-line projections are excellent at helping you make that kind of analysis.

Monte Carlo simulations deserve their own post, but I'll sum them up here: effectively, they take the expected return and volatility of a portfolio and use this input to run hundreds of simulated projections using those estimates. The output will look something like this:

The yellow area represents the most likely scenarios, the light brown less likely, and the dark brown least likely. As you can see, depending on how the numbers fall, an "8% average return" can have an extraordinarily wide range of outcomes! Monte Carlo simulations ensure that this (extremely important) aspect of financial planning is taken into account; rather than focusing solely on the median case (the blue line), you can look at the range of all simulated outcomes and ensure that a large majority end in success.

This is particularly important when choosing an asset allocation for your portfolio. A straight-line projection will always suggest that the most aggressive portfolio is best; after all, it will have the highest expected return! However, a Monte Carlo simulation may (and often does) show that the volatility of said portfolio decreases your overall chance of meeting your goals, as an unacceptably high percentage of scenarios have e.g. massive downturns right at retirement. (This is a great example of risk capacity, as separate from risk tolerance.)

As I've hinted throughout this description, it's not really an either-or choice; generally, you want to look at both straight-line projections and Monte Carlo simulations, in order to effectively analyze the effect of strategies over time and ensure that volatility is taken into consideration. (If your advisor only uses Excel for their planning and blinks when you ask them about Monte Carlo, I highly recommend you start shopping for another advisor!)

Goals-based v. cash-flow-based planning

Closely related to Monte Carlo v. straight-line projection is the idea of goals-based v. cash-flow based planning.

Goals-based planning starts with determining goals (buy a house, send kids to college, retire at a certain age), looks at the amount of money being set aside for each of those goals, and then runs Monte Carlo simulations to determine the chance of meeting each of those goals. The concept is relatively straightforward (assuming you have the right software), and doesn't require a lot of data-gathering, as each goal can be looked at in isolation.

Cash-flow-based planning looks to account for all income and expenses, and runs projections on your net worth from now until "the end of your plan" (generally an assumed death date). While this requires a lot more data -- pretty much all income, expenses, assets, and liabilities, both present and (expected) future -- the results can be much more interesting. Remember that Roth conversion analysis from earlier? Cash-flow-based planning will be projecting your taxes and portfolio income each year from now until the end of your plan, and thus is particularly qualified to calculate that crossover point we talked about.

Again, there's not so much a decision between goals-based and cash-flow-based planning; generally speaking, it's a good idea to have both!

One-time reports v. "portals"

Back in the dark ages (i.e. the 20th century), a financial plan was a document. It was generally a million pages long, full of tedious and hard-to-parse charts and graphs, each of which only occasionally held a nugget of actually-useful data. It was created when you first started working with the financial planner, and was updated rarely, if ever.

Nowadays, most (good) financial advisors know that such a document is nearly useless, except perhaps as an attempt to prove how smart they are. While a good financial plan can indeed start with a regularly-updated, easy-to-parse document ("here are the major things we agreed on, and here are charts that back up the decisions that we made, if ever you want to refer to them"), the 21st century has brought technology that enables you to see how your finances are doing in real-time. This is often referred to as a "client portal", and a good portal will let you take a look at:

  • Your net worth at a glance

  • Your income, expenses, assets, and liabilities

  • Your portfolio performance

  • Your spending

  • Your progress towards goals

  • Electronic copies of your financial documents

and a host of other financial information. Anything that can be calculated in real-time can -- and should -- be! (Also, it should look good. You're paying good money for a financial advisor -- you should at least get a decent user interface out of it!)

These portals are generally powered by account aggregation -- the same technology that allows apps like to have read-only access to your various bank, credit card, and investment accounts. While account aggregation is still an occasionally brittle technology (banks aren't incentivized to play nice on that front), the best portal providers are working with banks to develop stable and secure API interfaces. Regardless, any portal that doesn't offer account aggregation at all generally isn't worth the trouble!

So: Monte Carlo simulations, straight-line projections, goal-based planning, cash-flow-based planning, and a good client portal in addition to an up-to-date, easy-to-read financial plan document. While having all of these features is a solid indication of Good Financial Plans, there are certainly other planning features out there, and there are a select few advisors who are always trying to move the industry forward. If you've seen anything interesting not in the above list, please drop a comment below -- I'd love to hear about it!

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