Most people concerned with their financial well being will maintain a budget and keep track of how their investments are performing. People desiring to be more sophisticated in their financial planning might even hire a financial planner to help them target specific goals and develop an efficient way to achieve those goals. However, most people stop short of modeling their financial future. This articles touches on the meaning of financial modeling, its merits, ways to implement it and things to watch out for.
Financial modeling is the projection of a set of financial figures to some future point based on a set of assumptions. One might create a base model with assumptions that he or she believes to be the most probable and then vary certain assumptions to see what the outcome would be. This is done by every major company and is even required for many types of companies that fall under regulatory scrutiny. However, individuals rarely have used this valuable tool for their own financial well being.
The benefits to individuals of financial modeling in this author’s opinion are tremendous. Merely in order to build a financial model, an individual must have a grasp of several important items. One is having a good understanding of their current financial situation. Assumptions for financial models, such as expense levels, are often developed based on a person’s financial history. The base step for a financial model is for a person to have at least a rough plan for the actions they might take during the model period that would affect them financially. Each of the items is a valuable tool that would help an individual before a financial model is even started.
Once the financial model is created and a base model using the most likely assumptions is established, a person should have a clear picture of where they are going. A person might be pleasantly surprised or this might be a rude wake up call. Either way, the person is better off having the knowledge available to them.
The most valuable part of a financial model is its application to analyzing risk. Have you ever asked yourself what would happen if you retired early? Would your savings carry you? What if you lost your job? How long could you survive without your main source of income and what expenses would you need to eliminate or reduce? How would a major purchase such as a vacation home or a recreational vehicle affect your financial position? You may know that your current budget has room for the loan payments, but may the purchase derail your retirement plans? Financial modeling helps you answer the question, “What if?” By adjusting your assumptions to reflect different possibilities such as the ones I have mentioned here, you can identify and understand the risks to your financial future and even test how effective plans to mitigate those risks are.
There are several ways to build a financial model. If you have the skills to do so, you can build one yourself with a spreadsheet application such as Microsoft Excel. Many people are not that comfortable with financial mathematics. For those of you that fall in the latter category, there are still several options available. There is software available on the market at varied costs and levels of sophistication. Financial planners often offer this service for free in order to up-sell their other services. There are also consultants that will build a financial model for you. There are, of course, plusses and minuses with each of these methods.
If you chose to build your own, you will need to verify the output. Good techniques include entering only portions of your finances with known outcomes to test the results, testing extreme assumptions to make sure the output makes sense under those conditions and having someone with the appropriate background peer review your work.
If you chose to use a financial planner, you should be aware that his or her analysis may be geared more to up-selling their products than to giving you a detailed financial analysis. Also, beware of the software they use. It is unlikely the person putting your analysis together is the one who created the software. Therefore, the program might be a black box to the financial planner. This is often the cause for errors due to not understanding the computations that the program uses to perform the analysis.
The software option also presents this black box issue. If you choose to use software, you should make sure you have a good understanding of how the software works and what each input you enter means. Buying a software package that is user friendly, but still sophisticated in the calculations behind the seen is the best way to go.
Using a consultant is probably the best route. This is especially true if the consultant created proprietary software to create the model. A consultant can provide you sophisticated results displayed in an easy to understand manner. The consultant can explain what assumptions were made and any simplifications that were made in building the model. The consultant is also not going to try to up-sell you on other products. The main draw back to using a consultant is cost. Specialized attention to you as a customer is often on the expensive side. Also, the consultant has no other products other than his services to use to offset his charges.