Financial planning – Is it pointless to be too precise?

A great deal of financial planning is related to the future. That in itself creates huge challenges as any plan we create is inevitably going to have elements of error. As a profession, financial planning appears to becoming increasingly precise about a future we frankly know nothing about. This article explores the challenges of future prediction and our use of forecasting.

We quite rightly deride fortune tellers as charlatans and yet put a man in an expensive suit and get them to forecast the future, perhaps using elegant mathematics, and for some reason we wish to label them an expert, or use such forecasts as the basis of our decision making.

Despite being smart enough to know the future is unpredictable, we spend a huge amount of time attempting to predict it!

Everyone seems to have an opinion on the direction stocks will take, yet there are so many interconnecting factors (or opinions, or opinions of opinions!) that it seems foolhardy to even try. John Maynard Keynes explained this well enough in 1936 with his beauty contest analogy, and yet we still have entire TV channels devoted to stock market fortune telling!

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.
(Keynes, General Theory of Employment Interest and Money, 1936).

The only thing we can be certain about the future in relation to stocks is that the prices will change. We will continue to experience both short and prolonged periods of escalation, decline and extreme valuations. We will also on occasion, or perhaps frequently, be surprised by the markets direction. As J.P. Morgan once quipped when asked about what will happen with the prices of the stock market, ‘they will fluctuate’.

Famous hedge fund manager George Soros also had this to say on the subject.

The financial markets generally are unpredictable. So that one has to have different scenarios… The idea that you can actually predict what’s going to happen contradicts my way of looking at the market.

So why do we still pay any attention to stock forecasts? Why use complicated mathematics to predict the future? We all know that the past is not an indication of the future (it’s published on nearly every piece of investment material) and yet using past prices to create mathematical models of future prices is acceptable practice?

I think the answer lies in people’s desire for a good story and perhaps our desire to feel like we actually know what’s going on. We are constantly seeking reassurance.

This desire to explain every market movement can actually be detrimental to your investment performance as Investment Manager Tim Price recently discussed at

The irony is that most investors might be better served by cutting out the commentary altogether (an irony of which we are, of course, well aware). The psychologist Paul Andreassen showed that people who receive frequent news updates on their investments earn lower returns than those who get no news. The following is from a 2002 Fast Times article:

“The barrage of information and pseudo-information has been magnified by the explosion in financial news over the past decade. In the late 1980s, psychologist Paul B. Andreassen did a series of experiments with business students at MIT that showed that more news does not necessarily translate into better information. Andreassen divided students into two groups.

Each group selected a portfolio of stocks and knew enough about each stock to come up with what seemed like a fair price for it. Then Andreassen allowed one group to see only the changes in the prices of its stocks. Students in that group could buy and sell if they wanted, but all they knew was whether the price of a stock had gone up or down. The second group was allowed to see the changes in price and was also given a constant stream of financial news that supposedly explained what was happening with each stock.

Surprisingly, the less-informed group did far better than the group that was given all the news.

The reason, Andreassen suggested, was that news reports tend to overplay the importance of any particular piece of information. When a stock fell, its fall was typically portrayed as a sign that further trouble lay in wait, while a stock that was on the rise seemed to promise nothing but blue skies ahead. As a result, the students who had access to the news overreacted.

Because they took each piece of information as excessively meaningful, they bought and sold far more frequently than the people who were just looking at the price.” 

Perhaps then, we need to consider that our desire to seek explanations for everything is damaging to our investment prospects and uncertainty should be more readily embraced.

It is worth reflecting on the fact that our very existence as human beings is uncertain. As outlined in Nassim Taleb’s excellent book ‘Black Swan: The impact of the highly improbable’, apparently the probability of us even being here is roughly 1 in 400 trillion.

That should put the other risks we face into perspective. . .

Matching financial markets to a person’s life, an impossible task?

More problematic than future stock market forecasting are Financial Adviser attempts to make the performance of financial markets fit in with an individual’s life. Surely achieving this for all of your clients is an impossible task?

The opportune moments to invest are unlikely to correspond with the most convenient time for you to put away your cash. Furthermore the timescale for an attractive return may not fit in with an investor’s cash requirements.

Perhaps on occasion, individuals should consider adapting their life to financial markets not the other way around? (This happens on occasion when they take unexpected losses, holding out for a return to profit/break even, yet perhaps we should consider adapting from the outset?).

We tend to have simplified notions of long-term investment, stating that one shouldn’t invest unless you are prepared to put money away for 5 years or longer. This still takes no account of the price you are paying when you invest client funds.

An investor in 1999 making a 10-year investment into the FTSE 100 would have achieved a very disappointing return, especially compared to a 1-year return for an investor in the spring of 2003 or 2009.

Now hindsight can be a terrible curse of your ability to think rationally, but it indicates to me that perhaps price is more important when advising somebody whether to invest, rather than time?

How many of your clients have received the same advice and portfolio, yet obtained vastly different returns purely down to the original price they paid for their investments?

Both an adviser’s clients and an advisory firm would like investment markets that move in a linear fashion, yet the world doesn’t work like that. This has led to the proliferation of multi-asset funds, where the portfolio of non-correlating asset classes has smoothed out the volatility of returns, yet I feel there are even challenges with this approach.

1. low volatility doesn’t necessarily result in low risk, as explained by James Montier in a 2010 GMO White Paper

Problems with Policy Portfolios

Problem 1: Risk isn’t volatility.

To begin, we should ask ourselves why we are concerned with volatility as a measure of risk. Modern portfolio theory is so entrenched in the innermost workings of the world of finance that risk is typically defined as standard deviation or variance. However, risk isn’t a number. It is a concept. Ben Graham argued that we should focus on the danger of permanent loss of capital as a sensible measure of risk: What is the chance that I will see my capital permanently impaired by this investment?

This strikes me as a much more sensible viewpoint than the mathematically elegant but ultimately distracting practice of assuming that risk is equivalent to standard deviation. Volatility creates opportunity, not risk. As John Maynard Keynes long ago opined, “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”

For instance, let’s look at equity volatility. Exhibit 3 shows a measure of the volatility of the S&P 500. Were equities more risky in late 2007 or early 2009? If you follow the edicts of standard finance, then 2007 was a much less risky year than 2009.

Now, tell me again that risk and volatility are the same thing!

Exhibit 3: Risk ≠ Volatility Source: GMO, SG


2. Using a multi-asset approach means that you will often purchase assets that will perform mediocre at best, missing out on the opportunity of investing more funds into assets or sectors that offer more attractive returns. Whilst we do not know what the future has in store, I personally don’t think it’s sensible to invest in UK Gilts at the present time (please see my earlier article, Illusory Return and Very Real Risk for more details). Whilst it’s a challenge to move away from a benchmark, especially one that’s risk rated to a client’s situation, I feel following a multi-asset strategy without considering the assets within this approach is dangerous and fails to acknowledge that risk and value are subjective terms and continuously moving targets.

To help explain this, let me ask you a question.

Are you risking your capital to a greater extent purchasing an entire portfolio of equities when prices are low, or investing into a varied portfolio of equities, bonds and property when all of these market prices are high?

3. A significant amount of the research into correlation and investment returns uses data that has been largely influenced by the 25-year bull market in government bonds, the lowering of the base rate of money to historical lows and then finally, topped off with QE. We have to consider the possibility that these data inputs are invalid as they reflect an extreme period for financial markets, and thus any conclusions we draw from them may well also prove invalid.

4. Finally, with the number of investors operating similar multi-asset approaches increasing, it could lead to a convergence of correlation between asset classes, especially at times of investor panic for a simple reason.

When investors panic on mass, they wish to sell and if they hold multiple different assets, it is likely to be multiple assets that are sold off. If you want to go to cash, it doesn’t really matter whether you own stocks, bonds or property, you will sell these assets and go to cash.

What we may find is that a multi-asset approach reduces day to day volatility and your returns, but doesn’t necessarily help reduce volatility in extreme events. (With emphasis on ‘may’ this is about future uncertainty after all!). This happened in the financial crisis, but it remains to be seen whether this will be the norm.

Financial planning and risk – why do we often miss it?

As we are all aware of the risks inherent within financial markets, you would think we would be better at spotting them buildup before it is too late. I think this flaw in our ability can be explained somewhat by our human behavior.

Charlie Munger gave an excellent speech in June 1995 at Harvard University on the Pschology of Human Misjudgment. I highly recommend reading the full transcript. One of the behavioural biases we tend to have is the bias from contrast-caused distortions of sensation, perception and cognition.

If you throw a frog into very hot water, the frog will jump out, but if you put the frog in room temperature water and just slowly heat the water up, the frog will die there. If it comes to you in small pieces, you’re likely to miss, so if you’re going to be a person of good judgment, you have to do something about this warp in your head where it’s so misled by mere contrast.

Personally, I feel the charts below pretty much sum up a financial planners impossible task of matching the performance of financial markets with a client’s life events.

Financial planners: Here’s how to think about risk

It’s worth bearing in mind that in spite of many mathematical attempts at explaining, quantifying and managing risk, I feel the best explanation has been simply provided by Elroy Dimsen of the London Business School:

“Risk means more things can happen than will happen.”

Financial Planning: Future projections that use assumptions built upon a foundation of other assumptions

If financial markets themselves are unpredictable, how can we accurately make financial plans for people, with these plans themselves dependent upon financial market performance, future interest rates, future inflation rates, the health of our clients and their future life choices and circumstances? (To name just a few of the many factors involved!)

The uncomfortable truth is it’s impossible to get this 100% accurate and any plan is purely just projections built upon a foundation of assumptions and therefore is incorrect from the moment it’s written.

Does this mean that we shouldn’t plan?

I believe not, from my army days I remember a few phrases on planning which I feel are helpful in this regard.

Failing to prepare is preparing to fail.

Pre-planning and preparation prevents poor performance.

We need to plan for our future otherwise we will never achieve anything.

With respect to financial planning however, our desire to use mathematics and precision can make it more difficult for a layman, or even us for that matter, to actually make the correct decisions in the first place. We also run the risk of misleading clients by falsely reassuring them about a future we know nothing about.

This pretty much sums up my point.

The Commanding General is well aware the forecasts are no good. However, he needs them for planning purposes.

-Kenneth Arrow, Nobel Laureate Economist. . .recalling the response he and colleagues received during the Second World War when they demonstrated that the military’s long-term weather forecasts were useless (from Future Babble: Why Pundits Are Hedgehogs and Foxes Know Best, by Daniel Gardner)

Only through a thorough explanation of the world’s risks and by articulating the uncertainties we face, can we ensure clients make decisions based on reality and from a position of understanding.

If clients understand and accept the reality of risk and uncertainty, they will exercise more prudence in their financial planning. It will also help highlight the importance of sound investment management.

They may also be more forgiving when things don’t go according to plan, but perhaps that’s wishful thinking!

When creating plans for clients, the popularity of precise cash flow planning/projections and forecasts could potentially lead to the incorrect decisions being made.

Do we say to a young person that as their target fund is £x per year in retirement, they need to save £y per month as a precise figure, or is it better advice to explain they should simply save as much as they can afford?

I feel simplicity of the message should trump precision in this scenario.In my view, it’s far better to have a ‘problem’ of surplus savings, than the very real PROBLEM of too little.

When it comes to income planning for retirees, we’re in even more dangerous territory.

With a fixed amount of assets, we make forecasts using a number of assumptions on a ‘safe’ or reasonable amount of income somebody can withdraw from their investments.

Why is this so dangerous?

Firstly, any mistakes we make cannot be rectified by further labour on the part of the client to make up for the lost income or capital.

Secondly, it’s difficult to establish the right balance between living for the moment, and being a miser. Too much income in the earlier years could impoverish a client and too little can leave them missing out on lifelong dreams. Unfortunately, what this magic number is can only ever truly be ascertained on an individual basis, and even then it would require the lense of hindsight. A lense none of us possess.

Added to these difficulties is the uncertainty of when investment losses take place. Abraham Okusanya of Finalytiq has touched on some of these issues recently in his research paper ‘pound cost ravaging’ (again a must read for financial planners and Paraplanners), however whilst the further use of Monte Carlo models is a positive development in explaining the concept of uncertainty, it’s still not going to be helpful for clients who are the actual outliers, especially when those clients will experience financial hardship. Perhaps an extreme set of circumstances has the potential to ruin your clients portfolios on mass.

It’s worth bearing in mind that one or two mistakes in an investment portfolio can render the best-laid financial plans entirely useless.

Why is this territory so dangerous from an advisory perspective?

We have a duty to not impoverish our clients, combined with the need to keep them happy.

From my experience, I feel many clients tend to take as much income as we advise them to, placing the adviser in a position of blame if that withdrawal rate doesn’t work out. Simultaneously satisfying this desire for income and prolonging an investment fund for decades is unlikely to prove achievable – there simply has to be trade-offs.

Furthermore, my belief is that placing a warning paragraph about the risks of withdrawals on page 14 of a suitability report is highly unlikely to give advisers a get out of FOS complaint FREE card if things go wrong.

I expect the most sensible advice will be the most cautious, yet the most popular among clients may well be the advice which is the most reassuring and generous about how much income to take. In a people business, it’s easy for reassurance and generosity to take precedence, which may not prove wise.

Perhaps people’s desire for certainty requires more annuities and a return to more defined benefit schemes?

I think an annuity has it’s place, however the attractiveness of them has been decimated by government bond yields, resulting in what I expect will be poor outcomes for any retiree who required certainty in recent times. At annuity rates of 5% for example, you need to live for 20 years solely to return your original capital!

Far from being a low-risk option, it’s actually a very risky gamble on how long you will live.

They will seem more attractive when government bond yields rise and annuity rates are at 10% for example, but even then, consideration needs to be given to the return available directly from government bonds without handing over your capital.

Giving into people’s desire for certainty only creates additional problems if our experience of defined benefit schemes and state pensions is anything to go by.

Attempting to apply precision to the future has created a sorry mess in the realm of defined benefit schemes and state pension. We are going to have a very difficult time trying to either honour promises made, or explain to people that they can’t actually get what they’ve been promised, even though the capital isn’t actually there to back them up.

However because we’ve created the perception that it is, simply by providing a piece of paper saying that someone is entitled to it, everyone who now expects these payments will feel aggrieved if it’s taken away, even by a small amount (and perhaps quite rightly?). Yet how exactly can these promises be honoured without taking money away from somebody else? The money simply isn’t there.

I think we all well know the difficulty of trying to water down on promises that we make, just think of all the recent pension strikes by teachers and firemen as an example for just small reductions in their paper promises.

(As an aside this reaction to loss is partly why inflationary policy is so desirable for people in the business of making promises they cannot possibly keep – governments).

Again Charlie Munger discusses this behavioural bias in his 1995 speech.

bias from deprival super-reaction syndrome, including bias caused by present or threatened scarcity, including threatened removal of something almost possessed, but never possessed.

Here I took the Munger dog, a lovely, harmless dog. The only way to get that dog to bite you is to try and take something out of its mouth after it was already there. And you know, if you’ve tried to do takeaways in labor negotiations, you’ll know that the human version of that dog is there in all of us. And I have a neighbor, a predecessor who had a little island around the house, and his next door neighbor put a little pine tree on it that was about three feet high, and it turned his 180 degree view of the harbor into 179 3/4. Well they had a blood feud like the Hatfields and McCoys, and it went on and on and on…

I mean people are really crazy about minor decrements down. And then, if you act on them, then you get into reciprocation tendency, because you don’t just reciprocate affection, you reciprocate animosity, and the whole thing can escalate. And so huge insanities can come from just subconsciously over-weighing the importance of what you’re losing or almost getting and not getting.”

So by creating a linear perception in people’s minds through paper promises, we’ve created a scenario whereby any attempts to take away part of something that isn’t actually there will create huge anger amongst the individuals who expect such payments. It’s worth bearing this point in mind when managing client expectations of investment return in a very uncertain world.

I would conclude that we should be extremely careful when making plans, recognize the limits of our foresight and not attempt to be too precise about a future that hasn’t yet come to pass. In the words of Keynes,

Better to be roughly right than precisely wrong.

Please let me know your thoughts in the comment section below. It would be great to hear from you directly. Simply email and i’ll get back to you shortly.

Mark Underdown

Nomad Paraplanner