In this quote, Ian Wilson, former GE executive, offers some valuable insight that applies to financial planning:
“No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all of your decisions are about the future.”
An inconvenient truth in financial and investment planning is that we base many assumptions on what has occurred in the past. Also, all our knowledge is derived from what we learned from past occurrences.
When we calculate standard deviation (the possible variability of returns) on portfolios we use past investment returns. This gives us a good idea of how things MAY perform in the future, but because it is based on past information, there is no guarantee the future will follow along.
With financial planning we use past inflation rates as a gauge of what may happen in the future, does that mean it will? We can’t know for sure and that is why we must keep a couple things in mind.
We must try and prepare financially and behaviorally for the unknowable. This means when we create portfolios or financial plans we should test the extremes of what could occur, even if it hasn’t happened in the past.
If we think that we can assume 6% investment returns with 3% inflation for the next 30 years on a retirement plan, let’s test that plan at 4% returns with 3.5% inflation, doesn’t look nearly as rosy.
If you think you a moderate portfolio would produce investment fluctuations in one year of +12% to -10%, how would you handle a potential +15% to -25% scenario. I am betting you’d be fine with either of the positive returns.
We don’t know the future, nobody does, and if they act like they do run! We must accept this reality and plan accordingly.
If you haven’t recently reviewed your financial plan you should contact your CERTIFIED FINANCIAL PLANNER™ Practitioner.