Back-of-the-envelope financial planning calculation: What are its advantages and disadvantages?

When we invest for our financial goals, we heavily rely on the available calculators. You might use a straight forward compounding calculator or a sophisticated retirement calculator. Each of these calculators has some restrictions. The bitter truth about all these calculators is that we are basically making tons of assumptions.

If you look at a standard retirement calculator, you'll see that only three things are certain: Our age, the current spending we believe will be sufficient for our retirement, and the present amount of our collected savings. The remaining factors, such as retirement age, life expectancy, inflation, and investment returns, are all based on assumptions. Most of these presumptions are based on average historical factors.

Jim C. Oter, the author of the book "Unveiling the Retirement Myth," was right when he said that averages do not apply to specific people. However, whether it's a consideration of life expectancy, portfolio returns, or inflation, calculators are designed to force us to adopt averages.

The best answer to all these is “Back-of-the-envelope financial planning calculation”. Let's investigate this straight forward mathematical technique for our financial objectives.

Take this as an example. Suppose that after 15 years you will require about Rs. 50 lakhs (in today's value) for your child's educational needs. The calculation then proceeds as follows.

Amount required in today’s value(a): Rs.50,00,000

Goal Time Horizon(b): 10 Years

Yearly Savings Required(c=a/b): Rs.5,00,000

Monthly Savings Required(c/12): Rs.41,666

Let's say you had accumulated about Rs. 6,00,000 after a year. (Let us assume that the invested amount is ₹5,00,000 and the returns on it being Rs.1,00,000). The computation for the following year will be as follows.

Amount required in today’s value (a): Rs.50,00,000 – Rs.6,00,000 (existing assets) = Rs.44,00,000

Goal Time Horizon (b): 9 years

Yearly Savings Required(c=a/b): ₹4,88,888

Monthly Savings Required(c/12): ₹40,740

You must make an annual calculation in the same manner. If you believe that the current cost of education has gone up since last year's considerations, you must adjust your goal amount and make the necessary monthly payments.

It is a sign that the goal is out of reach for you if you are unable to make the necessary monthly investment. In that situation, you must lower the goal's cost.

Advantages

• Since you don't need to rely on complicated calculators, it is easy to grasp.
• Depending on affordability or inflationary change circumstances, you can raise or lower the goal's cost.
• The risk associated with "volatility of returns" will be indirectly offset. Because you invest more in that year when the cumulative corpus is lower as a result of market volatility. In the same way, if the market uptrend has a greater impact on accumulated corpus, you invest less in that year.
• This will restrict you from taking undue risk. Because in this calculation we are assuming the inflation rate is equal to portfolio return. Another way to say is real return is zero (Real Return = Portfolio Return-Inflation).

Disadvantages

• The major drawback of this computation is that it treats real returns as being zero for the whole goal period. However, in the real world, as the goal draws closer, we must move our equity assets to debt to shield ourselves from the risks like “sequence of returns risk” or “risk of volatility of returns”. The real return won't be zero once your equity assets shift to debt. This calculation fails to address it.
• It is not appropriate for goals where portfolio returns are projected to be lower, but your inflation rate is high. For instance, if the duration of the goal is slightly under five years and the inflation rate is eight per cent, we cannot anticipate eight per cent returns from the portfolio. Instead, the appropriate expectation from the portfolio should be between five and six per cent because we are allocating the portfolio to debt. In that scenario, our real returns are negative. However, if we use the calculating approach described above, we will automatically take the eight per cent portfolio return into account. This approach is highly risky for the goals where the inflation rate is higher than the return on the portfolio.
• This straight forward calculator can be used in one way only if we assume that portfolio returns are equal to the rate of inflation. We must use the standard formula to determine the necessary investable amount whenever our inflation rate exceeds the portfolio return forecast.

As I have already stated, no calculator is perfect and cannot account for variables like inflation, returns, or behavioural characteristics. Therefore, it is always preferable to invest as much as you can with a sensible asset allocation rather than relying too heavily on calculators.

Basavaraj Tonagatti, CFP, SEBI Registered Investment Adviser, Fee-Only Financial Planner, and Finance Blogger at BasuNivesh