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The Most Important Part of a Financial Plan: Room for Error

by | Financial Planning

“If you don’t know where you are going, you’ll end up someplace else.” (Yogi Berra)

A sound financial plan is invaluable. It looks ahead to what you want from your money and gives you a way of measuring how well you are doing in getting there.

It gives you a lot of confidence to be able to know how the different steps you are taking are leading you towards your goals. And seeing the plan working as months and years pass is both powerful and exciting.

However, a good financial plan also always comes with a condition: that you can never know what the future is really going to look like. You can make reasonable assumptions about what sort of returns you should expect over certain time periods, for example, but without a crystal ball, there is always a chance that those assumptions will be wrong.

One of the most important parts of a financial plan is taking this fact into account. You have to appreciate that no matter how well you plan, it is still possible for things to work out differently.

Upside, downside

This isn’t always necessarily negative. Sometimes markets will perform much better than you expected, and you might find yourself reaching certain goals much sooner than you planned. That requires you to have the flexibility to change your plan to set new, or bigger goals, or to alter your strategy to make sure you preserve the wealth you have built.

Sometimes, however, things won’t turn out to be quite as good as you hoped. Markets might underperform, your income might not grow as quickly as you expected, or you might have more children than you planned for.

In these situations, what you don’t want is something like this to derail your plan completely. What you need, in other words, is to build in room for error.

As author Morgan Housel writes:

“Room for error is underappreciated and misunderstood. It’s often viewed as a conservative hedge, used by those who don’t want to take much risk or aren’t confident in their views. But when used appropriately, it’s quite the opposite.”

Practical steps

Practically, what does this mean?

If you accept that a financial plan can never be fully accurate, because the future is unknowable, then you need to be able to deal with two distinct risks – things going wrong very quickly, or very slowly.

In other words, what would happen if a single big event disrupted your progress? Or if the assumptions in your plan are too optimistic over time?

Dealing with the former is perhaps easier. This is why having an emergency fund and insuring yourself are so important. If you get hit with a huge, unexpected expense, you want to be able to meet that without upsetting your entire plan. And if something happens to you or your partner causing you to lose a big portion of your income, you need to have a safety net.

Bridging the gap

Meeting the challenge of having room for error over the long term is more challenging. However, there are really two simple principles to employ.

Firstly, save more than you think you need to. As Housel notes: “Just save. You don’t need a specific reason to save. It’s great to save for a car, or a downpayment, or a medical emergency. But saving for things that are impossible to predict or define is one of the best reasons to save. Everyone’s life is a continuous chain or surprises. Savings that aren’t earmarked for anything in particular is a hedge against life’s inevitable ability to surprise the hell out of you.”

Secondly, don’t build a plan that just gets you to where you want to be based on reasonable assumptions. You need a margin for error. So have a plan that will get you 15% or 20% beyond your targets.

That way, markets can be 10% worse than you plan for over decades, and you will still comfortably make it to where you want to be. Or you can earn 10% less than you expect, and still sail through.

As Housel concludes:

“A gap between what could happen in the future and what you need to happen in the future in order do well is what gives you endurance, and endurance is what makes compounding magic over time.”

To discuss your financial plan, speak to us.

Disclaimer: The information provided herein should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your professional adviser for specific and detailed advice.

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