Hundreds of books and thousands of articles have been written on why one should have a personal financial plan. A financial plan is simply a strategy aimed at allowing you to have the money you need to have the future you envision.
Creating a financial plan is a great start, but it is not the silver bullet to all financial issues. The financial plan is not the end goal, it is the beginning.
For most, financial plans do not work as intended. The reasons are many. Understanding how the plan was developed, and understanding it’s ‘under the hood’ components will make your plan works for you instead of the other way around.
Here are some reasons why personal financial plans do not work.
Too Many Assumptions – A personal financial plan, like any other plan, is full of assumptions. For example:
- Number of years to retirement
- Money needed during retirement
- Number of years in retirement
- Expected rate of return
- Expected rate of inflation
- Expected future earnings
- Performance of your current investments
- Performance of your future investments
The farther away you are from retirement, more difficult it is to predict accurately. A small error in assumptions will have a significant impact on the performance of your plan. For example, if the financial plan assumes an average inflation rate of 10%, but the actual inflation turns out to be 11%, the actual performance will be way off compared to your plan.
A typical financial plan assumes numbers like inflation rate to be linear, meaning; inflation will increase at 10% year after year after year (in our above example). However, if the inflation is 12% for the first 5 years and then 8% for the next five years, the average inflation will still be 10%, but the performance of your financial plan will be very different than expected.
Mathematically, the probability of correctly predicting such parameters over a long period of time is very close to zero.
One has to understand that the financial plan is a model, and that the reality WILL be VERY different!
Not Understanding the assumptions – Very closely related to the previous point is this. When you pay someone to create a financial plan, you don’t really understand the assumptions that have gone into creating the plan. Most people get a great looking plan, but not one that can adapt to the changing reality. For example, most people wouldn’t know how to change the model when a key assumption turns out to be incorrect.
No Guidance on what to do when situation – Once we understand the underlying assumptions, it is very important for us to react when the underlying assumptions change. We have to adjust the financial plan to the new reality. In general, once the plan is created, we are expected to review it at least once a year or when there is a significant event in our life. For example, a birth or a child, or death of a spouse etc. Some plans include several “what if” scenarios to explain how the changes in assumptions impact the plan, but it most cases, we are on our own.
Difficult to Implement – Because of the complex nature, and the long duration of a typical financial plan, it is very difficult for a layman to put it in practice. After all, how many people have experience implementing projects that last several years? It takes a lot of discipline to execute the plan. It is very easy to find excuses that will put off the plan.
Difficult to Measure – How do you know if you are on track? Typically, the plan is made in isolation, and it is difficult to compare whether we are successfully executing the plan or not. Creation of the personal financial plan itself is overwhelming to most people. They do not have the plan reviewed with a professional on a regular basis.
It is very important to understand that all financial plans are made for illustration only, and there is no guarantee, implied or otherwise that they will come true. In the next article, we will discuss what you can do to overcome these challenges.
If you would like to learn how to build a financial plan and execute against it, download the FREE Lifebook, and start organizing your financial life. I will email you the next article as soon as I publish it.