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Weather Forecasting vs. Financial Planning

I have a confession - I'm a bit of weather geek. Mostly that manifests itself in the winter when I enjoy tracking potential snow storms. I've enjoyed snow since I was a kid and can still remember being the only kid watching the Weather Channel instead of cartoons for hours, before and during, big snow storms. Even though it's rare for a hurricane to impact us here in Baltimore, I also enjoy tracking and watching tropical systems develop.

We are now in the middle of hurricane season and there are a number of tropical systems in both the Atlantic and Pacific Oceans. You've probably seen (and will continue to see) discussions of potential impacts to the US from these tropical systems. You'll also see maps showing potential paths of the tropical system. I was looking at one of these so-called "spaghetti plots" the other day and it struck me how similar it was to some of the financial planning models we run for our clients. Here's a recent map of Tropical Depression #9, currently sitting in the Gulf of Mexico:

Each of the lines in this map represent a computer model's forecast of the future path of the storm. The computer models factor in hundreds of data points about the current weather environment. They also make a number of assumptions about future weather patterns and consider what has happened in the past with these types of conditions. Then they use all this information to attempt to predict what will happen in the future. Let's contrast that to a typical financial planning model from our software:

Again, each line represents a computer model's forecast for the future of this sample client's portfolio. We input into the system a number of data points about their financial picture, including their income, expenses, current portfolio values and asset allocation. We then input a number of assumptions about the future, like cash flow needs, tax rates, inflation and retirement income. Our computer model then looks at historical investment returns and attempts to predict the future value of the portfolio given various return scenarios.

Pretty similar aren't they? At this point you might be scared off from financial planning because, let's be honest, meteorologists are the butt of many jokes. Anytime they forecast 3 inches of snow and end up with rain, we complain about how the weather man/woman is always wrong. But in actuality it's pretty amazing to think they even knew a storm system was coming! Sure they won't always be exactly right, but they do a remarkable job of narrowing down the probabilities of future events. And that's exactly what we try to do in our planning. We can't tell you what the inflation rate or investment returns will be in the future, but we can model different scenarios to help you prepare for whatever the future might hold. 

There are many more insights from weather forecasting that can be applied to financial planning:
  1. Uncertainty Increases With Time - Look at those charts again. Notice how tightly clustered the lines are in the very beginning compared with how spread out they get over time? A small change tomorrow might not have a major impact on the future, but a number of small changes over an increasing amount of time will compound and make it much more difficult to predict the long-term future.
  2. Course Corrections Will Happen - Every day things change, both in your finances and in the weather. Tomorrow's spaghetti plots will look different from today's. You don't need to update your financial plan every few hours like the meteorologist does with his forecast, but your plan should be reassessed at least once a year. 
  3. The Future is Unpredictable - If a meteorologist ever tries to tell you exactly what will happen tomorrow or next week, it's probably best to ignore him the same way you ignore the financial pundit on CNBC telling you what the S&P 500 will do over the next year. Nobody can accurately predict the future in weather or the stock market, so instead we need to take what we know and try to estimate the probability of different outcomes.
  4. Be prepared for the "Worst Case Scenario"- We don't like to focus on the worst possible outcomes, but it's important to understand what they represent and to prepare for them because they could have a much higher potential impact than the best case scenario. If one computer model shows a major hurricane hitting heavily populated Miami, the meteorologists are going to be much more concerned about that even if it's an outlier compared to other models. If one of your financial planning scenarios shows you running out of money at age 70, we need to focus on how that could happen and prepare for what you'd do if that scenario came to pass, even if it's unlikely.
  5. Don't Get Caught Up in the News Hype - Last week some computer models were showing a hurricane forming and hitting South Florida and many news sites started to hype this potential threat. Just as the financial news loves to hype doom and gloom scenarios of potential stock market crashes, it's best to tune this out. The people of Miami don't start boarding up their homes every time a computer model shows a possible hurricane and you shouldn't get out of the stock market every time someone calls for a market crash. There are plenty of real meteorologists and real financial advisers out there who will provide useful information in a sensible and knowledgeable manner.
  6. Insurance Can Help Protect You - If you live in an area that is prone to tropical systems and flooding you likely have special insurance to cover your property if the worst case scenario occurs. There are many ways to help insure yourself for a worst case financial planning scenario as well. Diversification helps protect your portfolio. Life insurance protects your spouse and family. Long-term care insurance protects yourself. These are just a few of the many items you should consider.
  7. Quiet Times Won't Last Forever - The last major hurricane to make landfall in the U.S. was in 2005, a year when 4 major hurricanes made landfall, including Katrina. Certainly there have been other tropical systems that have caused major impacts in the U.S. (like Sandy in 2012), but historically there has been an average of 2 major hurricanes making landfall every 3 years. Similarly, the US stock market has not seen a major drawdown since the market bottom in March of 2009. Both of these streaks are impressive and might have led investors and coastal residents to let their guard down. Just remember, the good times won't last forever.
The key similarity between a good financial planner and a meteorologist is our desire to help people be prepared for what might happen in the future.  We don't know what the future holds but proper preparation and planning will help you navigate an uncertain future.
The views expressed represent the opinions of L.K. Benson & Company and are subject to change.  These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person.

Please see Additional Disclosures more information.