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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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