VR Logo

Quantitative Financial Planning

Financial planning is often plagued with vague questions, which can be answered by using this alternative way

The week before last, the Indian stock markets had one wonderful day which was attributed to the nuclear deal getting the approval of the Nuclear Suppliers Group. That day, even before the stock markets opened, the stock market punditocracy was certain that the NSG's approval would bring about some sort of a golden age. They were sure that the markets should take cognisance of this impending golden age right there, that very day, and in large measure. On the various TV channels, assorted businessmen and experts were asked leading questions about how the deal would benefit businesses. Those who gave answers that were anything less than gushingly enthusiastic were censored. I actually saw one of India's best known businessmen, whose last name is a household brand across the country, being shushed up in mid-sentence because he was somewhat less than enthusiastic about the deal's immediate benefits.

One of the things that strikes me about all these happy news points that improve 'sentiment' is the utter lack of attention to numbers. How much of an impact will a given event have and on how many listed companies? How much could profits improve by? And EPS?

The world is quantitative. The answer to a 'What' question is often meaningless unless an accompanying 'How Much' is also answered. I'm sure we've all experienced irritation when we get non-quantitative answers to questions that should be answered in numbers. When will my car be repaired? Soon. How far is that place? It's nearby. How much time will it take to get this done? Very little. Contrast this to a precise answer: How many extra Lok Sabha seats would the nuclear deal hype be worth in the coming elections? Zero. A much better way of answering, no?

Anyhow, one savings-related area which is plagued by vague, non-numeric questions and answers is financial planning, at least as it is generally delivered. The classic question here is 'How much is your risk tolerance?', to which no meaningful answer is possible. Instead, financial planning should be entirely done with questions that have quantitative answers. How much do you earn? How long will you keep earnings. How much money will you need for your child's education? When will you need that? When do you plan to buy a house? How much rent do you pay? Etcetra etcetra.

Here's an alternative way of doing financial planning. Write down all such questions you can think of and write estimated answers. Since the answers are all just estimates about the future, make slightly pessimistic guesses. The best way to write these down is not as questions or answers but as a series of cash inflows or outflows, along with the expected date for each. Wherever the amount is an estimate, write the optimistic amount as well as a pessimistic amount. Similarly, when the dates are uncertain, just write the nearest and the latest estimate. Now work your way down this list, adding and subtracting the incomes and expenses as you go. If you're handy with any spreadsheet software, this task is very simple. This is the best current estimate of your future financial history. Believe it or not, this is the difficult part of financial planning--the actual setting of the goals. We'll take forward the rest of the process in a future article, perhaps next week.