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WHEN IT COMES to financial decisions, there are, as I’ve argued before, two answers to every question: what the calculator says, and how you feel about it. There’s a fly in the ointment, though: Calculator answers might appear to be based in logic, but they’re still imperfect.
Why?
Ian Wilson, a former executive at General Electric, explained it this way: “No amount of sophistication is going to allay the fact that all knowledge is about the past, and all decisions are about the future.” In the absence of a crystal ball, in other words, even the most seemingly rigorous answer to any question will contain a kernel, if not more, of uncertainty.
Consider the question of how to establish an asset allocation. Most people’s first step would be to consult historical data, reviewing past returns for each asset class. That makes sense, and this is certainly how I approach it myself.
The challenge, though, is that historical numbers will never be able to perfectly predict the future. At best, they’re a guide, suggesting where things might go.
I mentioned recently, for example, investors’ experience in Japan’s stock market. During the 1980s, Japan’s economy boomed. But after peaking in 1989, the Nikkei Index went into a multi-decade slump, recovering only last year, after a long, 34-year slump. It’s doubtful, though, that even the most pessimistic observer could have predicted that result.
Such is the difficulty of using historical data. We can’t fully rely on it. And yet, despite its inherent weakness, we also can’t ignore it. Fortunately, there are ways to square this circle. To see how, we can examine four common financial questions.
Suppose you’re building a retirement plan and trying to estimate your annual expenses. You could do the math, and that’s certainly a good starting point. But just as with estimating market returns, that number will be necessarily imperfect. Especially when projecting many years into the future, expenses could turn out to be higher for any number of reasons.
Very often, for example, retirees use their newfound freedom to travel more. Or they might have higher healthcare expenses or might decide to help their adult children more. It’s very hard to predict, and that uncertainty can make it difficult to build a reliable plan.
The solution?
In this case, you could try inverting the question. Instead of asking whether your estimated expenses would be sustainable, ask what the maximum sustainable spending level might be. If you think your expenses will be $100,000, for example, test to see whether your assets would support spending of $150,000 or $200,000, or more. Try identifying that outer bound.
Insurance
You may be familiar with umbrella insurance, which provides additional liability coverage on top of standard home and auto insurance. It can be enormously valuable, but many people are unsure how much to purchase. One common approach is to match the coverage level to one’s net worth. Someone with $5 million, for example, might secure $5 million of coverage.
That’s one approach, but if you ask attorneys, they’ll tell you that the right coverage level is actually unknowable. That’s because judgments in accident cases are driven by the damages involved, so someone’s net worth generally isn’t relevant.
At the same time, however, attorneys will also acknowledge that, all things being equal, personal injury lawyers will always prefer to pursue someone with a higher net worth.
In other words, net worth shouldn’t matter, but it does. As a result, there ends up being no single, mathematically “correct” way to choose a coverage level. Each approach has some merit but is also imperfect.
How can you arrive at an answer?
In this case, a good approach might be to triangulate. Use the numbers derived from each perspective to arrive at a final answer that seems to make sense.
Gifting
If you have adult children and are thinking about helping them financially, that’s another area where the calculator can’t provide a perfect answer. That’s because it involves the intersection of money and family relationships.
Consider a discussion that the late Charlie Munger once had with a friend. Charlie’s friend asked him if he planned to leave his fortune to his children. Charlie said yes. His friend then asked if he worried it might have an adverse effect on his children’s work ethic. Charlie’s response: “Of course it will, but you still have to do it. Because if you don’t give them the money, they’ll hate you.” In other words, this isn’t just a math problem.
Another complicating factor is equity. If you have more than one child, chances are that their financial circumstances are not all the same. And yet, on principle, many parents feel that children should be treated equally.
And finally, there’s the question of when to make gifts. Should gifts be made early, to help children as they’re getting started, or only after they’ve settled down? Or should they receive gifts much later, only by way of inheritance?
None of these questions is easy, and none has a mathematically right answer. The solution? My suggestion would be to just get started.
Choose a modest number for some initial gifts, then assess how things go. See how your children react to that first gift and how they use it. That information can then inform the size, pace and structure of future gifts.
Trusts. Suppose you want to use a trust to convey assets to your children. It sounds simple, until you consider the question of how and when to distribute those assets. You could specify distributions at specific ages or stages, like when a child reaches 25 or 35 years old, for example, or when they get married. Or you could limit distributions to specific needs, such as education or a home purchase. Another approach would be to limit distributions to a fixed percentage each year.
Each framework is logical in its own way but also carries flaws. That’s why some parents decide to leave distributions entirely to the trustee’s discretion. Adding this element of human judgment might seem to sidestep other complications, but that too is imperfect, as many families find out. Trustees are human, and thus imperfect as well.
What’s a solution? In this case, keep in mind that financial decisions need not be viewed through an either-or lens. Instead, you could go with a hybrid approach. You might include a distribution timetable according to your children’s ages but also allow the trustee to override that timetable in specific circumstances—perhaps for the purchase of a home.
Stephen Schwarzman, the billionaire founder of the Blackstone Group, jokes that his math skills are “primitive.” In his view, though, he’s been successful because financial decision-making isn’t just about the math and doesn’t require perfect precision. More than anything, he says, it requires the ability to make judgments in the face of incomplete information.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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I learned in business that understanding an Excel spreadsheet actually requires one to know a separate language, because there are always a number of individual cells that are uniquely subject to question and can’t be explained by the number alone.
These cells demand explanation, invite dissent, trigger discussion, and convey nuance. Executives will debate for long periods about what information should be considered and what should be given priority in filling in the blanks. The discussion of one cell can result in a change of strategy and make or break a quarterly financial report.
The same types of analysis go into everyday financial decisions. You may keep a kind of spreadsheet in your head, but you also keep it in your gut.
Good article Adam.
Planning and calculators use assumptions that guide decision making. If your assumptions are off, your decision making will also be off.
I usually use 3 targets: expected, best case and worst case. I can still be wrong, but if worst case is acceptable, I will likely still be ok.
Excellent article! I struggle with the exact items you outline.
maybe a different author talked more about inflation. but there’s a comment on here about 130+-%/30 yrs inflation. i’ve long thought that if i think i’ve got enuf now, if inflation eats half of it in 20 yrs, i’d be ok w/that. it’d still be plenty.
another way of sayin’ it is if the number stays the same. say a million bucks. if i still have a million bucks in 20 yrs, i’ll be happy, even if it’s value is half.
I would add one thing about leaving assets to your children. Be transparent. Let them know what the plan is and your reasoning. They may have valuable input and offer differing perspectives that might not occur to us.
Paying off your mortgage is another area where the calculator and the emotions/intuition might lead to different conclusions.
i try to allow the math/history to inform my decisions, but not dictate them.
“financial decision-making isn’t just about the math and doesn’t require perfect precision. More than anything, he says, it requires the ability to make judgments in the face of incomplete information.”
Best summary!! Judgments come from maturity, not calculations or emotions.
Adam,
This week’s article hit close to home. With 3 grown children, each with very different financial circumstances, we’ve had to navigate some interesting challenges. It reminds of the saying that all major decisions are half based on rational thinking and half on Shakespeare (personal drama).
Adam, another EXCELLENT article. Better to plan, than not. And that is the main point, no one can be a perfect planner, but it is my belief you learn a lot by planning. One thing is for sure, you need to save for retirement, and fund those IRA’s or equivalents as best you can, the more the better. At 79, I want you all to know, retirement is not cheaper. As the article states get a handle on what is practical, and from my personal experience, do not plan on retirement at 80% but at 100% of your previous income. And in that way, if you have extra, that is all the better. Reality, is many lower middle income folks just do not have enough to prepare for retirement, but you should still do your best to SAVE.
A reminder of the old saying “Fools plan, but the future decides.”
Most planning tools are just that: tools. Tools are made to help us better identify possible future outcomes, but they are not crystal balls that can actually tell us what the future holds. As I often told clients who were seeking greater certainty “If I could read the future, I’d be rich and you’d be talking to my replacement.”
On a more practical level, we all need to understand that any plan only encompasses a moment in time and to remain effective, our plans need to be regularly updated to meet changing circumstances. Estate plans are not a one and done effort. Financial plans are even more volatile.
“ Ask what the maximum sustainable spending level might be”. I follow this guideline when thinking about spending after full retirement in a few years. I keep two numbers in mind–our actual, usual spending and the outside safe possibility. I also use it to think about what we could spend now if we needed to make a big purchase.
On your last point: After my father retired as head administrator of a school district, I asked him why a man I knew was talented had not moved past the job he held for many years. He said, “he couldn’t make a decision”.
How much umbrella insurance to get? I look at the total exposure (within reason). If I have a $5 million net worth and $3 million of that is in IRAs then I consider what state I live in. My state protects all IRAs from creditors so my real exposure is only $2 million and that would be my umbrella amount. (I made up those numbers 🙂
Lawyers don’t like going after physical assets, so primary houses / property are pretty safe and can be excluded from the above ponderings, though I wouldn’t.
It is amazing the dismal IRA protections provided by some states, eg. California & Wyoming, so be sure to check out your state.
Great observation/quote: “No amount of sophistication is going to allay the fact that all knowledge is about the past, and all decisions are about the future.”
The corollary to that comes from a danish proverb, which baseball fans often attribute to Yogi Berra, a pro baseball player whose stats put him in the top 10 players of all time (15-time All-Star, 3-time AL MVP, 10-time World Series Champ): “It’s tough to make predictions, especially about the future.”
Adam, this is an outstanding outstanding article. People desire a financial plan to provide guidelines for the future. Providing calculations based on assumptions and historical data can be valuable. But these same numbers provide a false sense of security since unknowns remain.The notion of being able to OPTIMIZE each decision related to asset allocation, gifting and what type of trust (if any) may be an illusion.There are always more things to consider with changing circumstances. In your excellent piece, you do not propose a definite solution, but rather a helpful process on how to act under uncertainty.
I would add the concept of “simplicity” can be the decisive tie breaker when moving forward. For those of us who over think these issues, there is a point of diminishing return. Even a wise decision maker may not be the one implementing it in the future. You still rely on how well those given this future responsibility may handle it. The more complex the solution, the better chance the hand off will be different than expected. For example, as you astutely point out, trust companies are people too. If one believes these professionals will automatically give as much thought about your family issues as you do because of an overly complicated legal document, you may be disappointed. A simpler approach may be implemented closer to what was your intent.
So many decisions we all make, not just about investing, but in life must be made without knowing all the variables. You discussed some reasonable methods to use when doing so. Very nice article, Adam.
I had this published as a comment to the editor at Forbe’s several years ago. Your comments on umbrella insurance (which I agree with) reminded me of it.
The agonizing problem of valuing human life after an accident (“Human values,” June 14, p. 189) has no easy solution. But one quick method would be to pay the same amount the deceased carried on themselves in life insurance. It’s always amazing that someone who carries $100,000 in life insurance is worth S2 million after they’ve been killed in a situation where someone else is liable. Let them fall asleep at the wheel and they’re worth S100,000. Let someone else fall asleep at the wheel and all of a sudden they’re worth S2 million.
But some of us have no reason to carry life insurance. I have no dependents: does that mean my life has no value?
My brother was a claims adjuster. An insured had killed a 17 year old girl, the parent’s only child, in a car accident. How much do you think the company should have paid them?
A lot more than they should pay for me, given I’m 78. How much did they pay, and who decided?
I didn’t want a cop out. Give me a dollar amount that you think a 17-year-old girls life is worth?
You’re the one who raised the issue, so you should answer. However, I see that the US Department of Transportation values a Statistical Life at $13.7 million, so let’s start there.
Thanks for acknowledging these realities and uncertainties. So much of what you wrote rings true for me.
We are well situated financially, and have a 30ish year time horizon. We have done just what you suggested with our adult kids, providing modest gifts to each. Now we’ll see what the future brings, and go from there.
Regarding AA, agree. The bond or cash tent approach has always made good sense to me, ie decreasing equity exposure as retirement approaches, and then increasing it over some period of time as Seq of Returns risk diminishes over the years. Have always been puzzled that that approach is not more popular.
But, did you account for the biggest killer of wealth over 30 years, a 3% inflation is 142.7% for 30 years, or that means something costing $100 today would cost $242.70 in 30 years if inflation averages 3% annually. So I went the other way, about 80% in the S&P 500 and 20% cash, to tide me over in the lean years. S&P average about 9% in the past, but next 30 years maybe 7%. My take after many years in retirement, now at 79. Select the approach which works for you.
I did. Our asset allocation makes sense for our partic situation.
I understand inflation and factor it in to our plan. In this first phase of retirement I worry a more about spending shocks – prolonged health issues or major life upheavals in family for which money would be needed. I am hedging against those by holding more short term treasuries than others might. Will adjust as time horizon shrinks.