Model Behavior: Benefits and Limitations of Financial ModelingSubmitted by Bernhardt Wealth Management on April 1st, 2019
We all use models of various types every day. Did you check the weather forecast before getting dressed for work? You used a model. The last time you used the map application on your smart phone to find an unfamiliar address? You used a model then, too. In fact, any time you look at something to make an estimate or judgment—the length of a piece of rope, the width of a sheet of plywood, the color of a paint chip—you’re constructing a model in your mind to predict how something will fit, appear, or otherwise work for your future purposes.
Financial models are an important tool for investors and financial professionals, including advisors. Various firms, product providers, and other entities utilize sophisticated financial modeling to predict how various types of assets and portfolios will perform under certain market and economic conditions. But, like all the models mentioned above and regardless of their sophistication, financial models have a number of limitations that should be considered.
Let’s go back to our smart phone map. Most of us have had the experience of taking the fastest route shown by our app, only to realize en route that the road our map is telling us to use is under construction. Or, thinking about that handy weather forecast, how many times have you gotten caught in a sudden, unexpected shower on a day that was supposed to be “mostly sunny”? In other words, no model is perfect. Another way of saying it is, “The map isn’t the territory.” A model can give us a reasonable prediction, based on certain assumptions. But if an assumption turns out to be incorrect, or if something “on the ground” changes unexpectedly, the predictive value of the model will be decreased.
In our work with thoughtful investors, we make frequent use of field-tested, science-based, data-driven financial modeling. But at the same time, we make sure our clients understand the assumptions we are employing and the impossibility of knowing in advance which of these assumptions could be altered by actual future events. In fact, one of the most common simulations we run to help clients anticipate future financial outcomes is called a “Monte Carlo Simulation.” Let the implications of the name soak in for a minute… Just as in the casinos in Monte Carlo, there is a degree of uncertainty about any predicted financial outcome. We help clients look at a variety of possible scenarios and then make decisions designed to offer the highest odds of success, but as we all know, nothing about the future is guaranteed. This is not the same thing as taking wild guesses and hoping for the best—far from it. But no model is perfect, and no prediction based on a model, regardless of how sophisticated the model may be, will be correct 100% of the time.
A professional, fiduciary financial advisor can help you sort through the many variables and options to arrive at a strategy that will give you the best long-term chance for financial success. If you are interested in seeing how financial modeling can increase your odds, we would love to talk with you.