Many people focus on a single indicator, such as whether they are saving enough for retirement or carrying too much student-loan debt, writes financial literacy expert Annamaria Lusardi for the WSJ’s Experts blog. The problem with such an approach is that planning must be multifaceted to be effective. Ms. Lusardi, the Denit Trust Chair of Economics and Accountancy at the George Washington University School of Business, writes that there is a short financial checkup to effectively predict key components of an individual’s financial health. The six-question test, which is based on a body of national and international research, evaluates four key areas: ability to meet expenses, advance planning, management of finances, and financial knowledge.
At North Capital, we’ve developed a proprietary financial planning framework that is simpler in approach, but more complex and robust in results. Dubbed the PRIM system, we believe that an effective personal financial strategy has four components: planning, research and recommendations, implementation, and monitoring. Planning requires more than six questions: even the simplest plan should provide for customization and nuance, as small changes in an individual’s starting plan will have dramatic impacts later in life. Our planning process collects factual and behavioral information to discern and quantify clients’ needs and goals. As we have in other parts of our practice, we have applied a planning approach that is widely utilized in institutional circles: liability-based planning.
If you think about your own future financial picture as a series of obligations and objectives, with probabilities attached to each such need or want, determining future cash flow requirements becomes a (complex but solvable) problem of financial arithmetic, probability analysis, and stress and scenario testing. Use of probability analysis allows us to analyze shortfall risk (the probability that particular needs or goals are not met) and risk sensitivity (the probability that outcomes are affected by particular inputs). Not surprisingly, we find that most individuals’ financial futures are affected far more by their saving and spending rates, relative to their income, than by investment performance. A solid savings plan will endure through most adverse market scenarios, while outstanding investment scenarios cannot rescue someone from under-saving and over-spending.
The implementation and monitoring part of our four-step process, where we implement a tailored risk-based and goal-based investment strategy, is where most “robo advisor” focus their attention today. But as one cynical advisor recently remarked to me, “there’s a lot of venture money being spent to get to 60-40,” making fun of the tendency of most robo systems to lump clients into a “moderately aggressive” bucket with an asset allocation of 60% equities / 40% fixed income. Our model portfolios incorporate a risk component, and our moderately aggressive portfolio is close to 60-40, but we offer a more multifaceted and broadly diversified asset allocation than most, with dozens of models designed to meet the particular needs of our clients. For example, many advisors, and virtually every robo advisor, ignore income strategies such as preferred stocks, MLPs, BDCs, international REITs, high yield munis, and other microstrategies, although retired investors usually cite “income” as one of their primary investment objectives. Alternative strategies, such as private lending funds and peer-to-peer lending, also are generally ignored by the advisory community, even though they may deliver extra return at the margin.
One of Ms. Lusardi’s metrics, financial knowledge, is certainly an area in which all investors and advisors should continually invest. Even though investing is one of the world’s oldest professions, insights and innovation continue to advance our collective knowledge and wisdom.