Blessed by the Potato

Let’s think of financial planning as taking a voyage across the ocean. I appreciate that this is likely a poor choice of metaphors as I am not a sailor and neither are you, but let’s work through it.

You set off with some destination in mind. Checking the map and detailed charts with the typical winds and currents ahead, you draw a line to plot your course (with the help of some basic high school trigonometry to factor in the wind and current). A glance at the stars to be sure, you set your sails and put your back into the oars. The journey of a lifetime!

Within minutes you find you’re off course: a particularly larger than average wave has just moved your bow a degree off course and slowed you imperceptibly (though your instruments can give you the course deviation to two decimal places). No matter, a quick calculation, a pull on the oars and an adjustment of the rudder has set you right again. Then another wave. And a gust of wind… which then suddenly dies.

The conclusion is obvious: you simply can’t adjust for every ripple, it would drive you mad and lead to needless effort trying to compensate for tiny effects that may just cancel themselves out anyway. But you can’t very well cross an ocean without making a few course adjustments, otherwise when you do hit shore (if you hit shore) you may find out that you’re way off target. Ending up in Bangor, Maine is way worse than ending up in Newfoundland. Have you read Stephen King’s documentaries on the horrors plaguing Maine? Some kind of compromise has to be reached that will let you respond to the important changes so that you can get back on course, without over-correcting to everything.

You can play it by ear, and try to feel your way towards a happy medium, but that might involve some white-knuckle moments early on as you over-react to every tiny ripple along the way. In physics we (by which I mean Michael James) might put a low pass filter on the response function, or perhaps a hysteresis, to make the input-adjustment mechanism work better. When sailing you might only check the stars once a night, and hold the tiller steady against the waves.

To leave the metaphor and talk about financial planning, for problems like this there are lots of other practical solutions. You could just limit how often you check when you’re off course (once a year, say), or act only when you’re off course by some threshold (like when your asset allocation is off by more than 5%). Many of these adjustments will be minor if the perturbation is small: normal fluctuations in return or expected lumpiness in your monthly spending. Some will come on suddenly: though you may model and anticipate inflation as a continuous, steady percentage, you may find instead that your bills are perfectly flat through the year until March when your utilities jump 7% all at once while Mac & Cheese goes from $0.99 to $1.29 without hitting any of the intermediate values.

Some adjustments may be more major, and require much more of an effort to correct for. Like disability, losing a job, or a major global market crash. They’re also usually highly emotional times, which can lead to less-than-optimal decision-making. The midst of a market crash is the last time you want to be re-evaluating your risk tolerance and end up selling low, and while you’re sick may not be the time to rework your financial plan. So part of the planning process should, ideally, involve sketching out your course corrections in advance.

I don’t much care precisely how you go about it or what your contingency plans are, just that you think about it and come up with some. Don’t want to dictate how you make your course adjustments, just that you do. Thankfully, Michael James had a recent post on coming up with a formula for adjusting spending in retirement based on changes in portfolio returns. A generalized scheme might have two relatively simple components:

1. Identify, in advance, points where you will assess your progress. Decide how you will measure that progress, and what deviation would call for corrective action. What events are worth responding to, which aren’t?

2. Decide what action you will take while things are calm and you have your background research front of mind. Write your contingency plans down. You don’t want to be making those decisions while emotional after realizing that your plan is not working out, or trusting a plan from years earlier to a foggy memory.

For example, if you find after 5 years that your savings rate has lagged (perhaps because you can’t stay on budget, perhaps because of several emergencies/unemployment/etc), how would you get back on track? What would you do to your budget, how would your investments change? If equity returns were lower than planned for 10 years, would you put more into equities because you expect some mean reversion, or less because they’re losing and dumb? This is one area where your answer in advance might be different than your emotional answer later, and where you get into sticky questions of whether the data that led to your expected values was simply wrong. Would you stick with your asset allocation and adjust your budget?

What if things were looking better than planned: you had more money saved thanks to good budget discipline, luck, or good equity markets. Would you relax your budget and let yourself spend more, or would you remove some risk by shifting your asset allocation? Perhaps you’d prefer to stick to the original plan and keep the extra headroom — if there continues to be a surplus your heirs can have it, or you can retire early.

There is uncertainty in the world. This makes people deeply uncomfortable. The solution is not to pretend that the uncertainty is not there, but to prepare for it.