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

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

Updated: 03 May 2023, 08:34 AM IST
TL;DR.

## Back-of-the-envelope calculation is a straight forward financial planning technique that helps us to estimate the amount we need to save for our goals.

Back-of-the-envelope financial planning calculation

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.

• 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).