Margins of safety when financial planning

When creating your financial plan we are going to get some factors wrong. When investing mistakes will be made.

But don’t worry. Investing and financial planning are about allocating your resources sensibly for the future. The very nature of the future (i.e. it hasn’t happened yet) ensures there will be error.

Only a crackpot fortuneteller, or charlatan in a suit would appear certain about a future that is entirely unpredictable and that we frankly know nothing about.

Knowing that the future is unpredictable, accepting that fact and understanding it’s consequences, is an important part of the financial planning and investment process.

It’s simply common sense that will ensure you make sensible financial choices using foresight, rather than leaving you scrambling in the future wishing you knew now what you are going to when the future comes to pass.

We are all intelligent people with hindsight, but that is not going to help you today or in the future. You can’t eat past investment performance and we haven’t yet invented a way to travel back in time and fix our mistakes.

This is why it is so important to use the concept of prudence in both your financial planning and investment portfolio.

You need to build in margins of safety.

Margins of safety when projecting prosperity

Financial planning is basically just projections, using assumptions that are built on a foundation of other assumptions.

You need to understand that despite how valuable financial planning can be for your behaviour and financial decision-making, we are operating on intellectual quicksand.

It’s basically just educated guess work.

Here are just a few of the factors that would be used in your financial plan and the issues with them:

Inflation of prices

It’s difficult enough to select what measure to use, let alone predict what it’s going to be over the next few years or even decades.

Traditionally we used RPI, but people are now using CPI more commonly (which conveniently tends to be a lower measure).

This article provides a brief overview of the difference between RPI and CPI. I think you should stick to using RPI because it will be the higher figure and therefore will automatically build in some margin of safety.

But what if you are retired? You will spend your money on different things to the rest of the population and therefore will be affected differently by price increases of certain items.

AgeUK came up with something called the SilverRPI which illustrated that the true price increases for those in later life will tend to be higher than that measured by traditional RPI/CPI.

Whilst we all measure our prosperity using average measurement tools, most of us will not have average expenditures and therefore our own personal price increases and inflation rates will be slightly different to everyone else.

We can only use the average measures, but we need to understand that our personal inflation rates will have a margin of error to those quotes by the ONS.

After deciding which measurement of inflation is sensible to use, we need to project what it will be in the future. This now raises further challenges.

Let’s take RPI – the retail price index

Since1949 to 2015, the index has recorded average price inflation of 5.44% pa.

But averages are usually misleading. This quote from WIE Gates explains the difficulty of averages,

Looking at the chart of RPI over the period, you can see that a spike in inflation during the 1970s skews the average.

In terms that are more useful to understand, the purchasing power of £100 at the beginning of 1949 has depreciated to be worth a tiny £2.36 at the end of 2015 (as measured by RPI).

But what inflation rate will you suffer in the future? Will you receive a 10-year inflation rate like the 1970s, where £100 at the start became worth only £25.92 at the end of the decade?

Or will you experience inflation similar to the first decade of the 21^st century, where £100 at the beginning of 2000, became worth £76.68 by 2010.

The truth of the matter is you cannot predict inflation and therefore it is sensible to use the average figure, however misleading and incorrect it will be. This is because the average incorporates the extreme scenarios into the figures.

By using the average measure you should automatically build a margin of safety into your financial plan. This happens because in most years you will overestimate inflation, but this overestimation in low inflating years will ensure you don’t suffer the same level of financial shock as you would have if you projected a lower inflation rate and then suffer through a high period of inflation.

Taxes

Tax has a large affect on how much money you have to spend and also on the prices of goods and services that you spend your money on.

There could be obvious tax increases, like an increase to the basic rate income tax from 20% to 25%, or more hidden but still very real tax increases, like an increase on import duties or on certain businesses which will affect the price you pay in store for certain items.

The longer the time horizon, the higher the probability that tax rates will not be the same as they are today.

Unfortunately you can only plan with what you know today, but it raises a very important concept for financial planning.

Do not let current tax rules unduly sway your thinking and push you to invest too much of your money into one particular tax wrapper or tax beneficial investment asset.

You have to keep in your mind the likelihood for taxes to change and not have all your eggs in one tax induced basket.

It’s essential to have balanced finances to ensure that specific tax changes will not have too great a detriment to your level of prosperity.

Of course, if you see oppressive tax changes across the board, then it’s rather difficult to escape from their effects; but being overly exposed to one tax increase, or a tax relating to one specific asset, is entirely avoidable with a little bit of foresight and balanced financial planning.

Life expectancy

When will you die?

It’s rather an unappealing subject to think about, yet it’s important factor to consider for financial planning purposes.

(As an aside if you could find out exactly when you would die would you really want that information? – I certainly wouldn’t).

Your life expectancy is a large missing piece of your financial planning puzzle.

It’s a little bit like the Holy Grail of financial planning. If we knew this figure financial planning would be a whole lot easier.

It’s so important because you need to find out how long your money will need to last to figure out how much you can spend. For the vast majority of the population you will not have enough savings to rely entirely on the income from your investments; you will have to gradually eat both capital and income.

Spend too much too soon and you are left with insufficient capital to provide the necessary amount of income.

Don’t have the very real problem of too much life at the end of your money.

Spend too little and you could miss out on lifelong dreams, or simply miss out on a higher level of comfort and convenience in later life.

We can usefully use average life expectancy tables to get an idea of how long you will live and financially speaking it’s sensible to plan as if you will live to 100 (but actually try to live as if you will die tomorrow).

Unfortunately, life expectancy tables suffer from the same issues with misleading averages that inflation data suffers from.

You could be a smoker who lives beyond 100, or be a salad eating body worshiper and get run over by a bus tomorrow. Unfortunately those extremes can and do happen.

We have to use statistics in our planning, but again remembering that you aren’t going to be average, you will be unique.

You therefore need to be prudent in the amount of income you take, whilst still ensuring you don’t become the modern version of Ebenezer Scrooge.

Prudent in your projections

When financial planning you should therefore try and cover different scenarios, be conservative in your estimates and prudent in your projections. Some ideas are as follows:

• If you think you need to keep 6 months as a cash reserve, keep a little more; 7-12 months, maybe even as much as two years.

• If you think you need to save £200 per month until retirement, try and save £300.

• If you think you will obtain a long-term investment return of 7%, budget as if you will only receive 6%.

• Don’t overstretch your finances. If you think you can afford to borrow up to £200,000 for a mortgage, try and only borrow £150,000. If that means a smaller house, or not getting a new kitchen; so be it.

• If you think you will live until age 90, keep enough money to live until 100.

• If you think inflation will be only 3% a year, assume 4%. If using statistics, ensure you capture all scenarios (the extremes and outliers) into your figures.

• Take enough retirement income to make you happy and comfortable, but don’t be misled by capital values into thinking you are wealthier than you really are.

• Keep a balance to your finances. Don’t let the tax tail wag the investment dog. Understand that taxes can, do and are likely to change.

There’s no magic wand when managing your finances. It is essential to keep your feet firmly on the ground. Prudence, foresight and using margins of safety will ensure your lasting prosperity.

Rapper Biggie Smalls famously said:

With all the factors and complexities involved in managing your money that certainly rings true, but for one crucial fact.

I would much rather have the problems of too much money, than the very real PROBLEM of too little.