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Michael Pope Blog post by Michael Pope

One more look at predicting the Future

In the previous article, we discussed one of the key factors in developing a long-term wealth building strategy  –  the need to “predict”, or at least make assumptions about, how household cashflows will change over time.  Before starting any investment with a goal of building wealth, it is critical to have a clear picture of the anticipated cash required to fund the investment strategy, based on assumptions about the future financial performance of the investment, and the anticipated amount of cash available, based on assumptions about the future financial performance of the investor, and to be satisfied that the amount of cash expected to be available at any given time will be more than, or at least as much as, the amount of cash required.

But making decisions based on a series of assumptions about the future raises one obvious question  –  what if the future doesn’t turn out the way we have predicted?

There are so many factors that will influence the outcome of an investment strategy that it is inconceivable that every one of those factors will behave as predicted over the entire lifetime of the strategy  –  there will inevitably be differences between the predictions or assumptions made during the planning of the strategy and the way things actually turn out.

Some of the differences between our predictions and what actually happens will not be too important in the overall outcome.  We may have made assumptions about financial factors that vary over time, such as Interest Rates, Capital Growth of our selected assets, Yields of our selected assets, etc. and looking at past values, it is obvious that variables like these have changed from year to year.  However, for simplicity when making an assumption about future values, we would be most likely to use a number which represents our expectation of the long-term average values of these factors in our projections.  As long as the actual results tend to average out over time to be as good as, or better than, our chosen values, it should not make a significant difference if the actual values are higher in some years and lower in others.

Other differences may have a more significant impact. And be more difficult to predict.

One of the factors we have identified as key to an investment strategy is the availability of surplus household cash flow to fund the investment during the early years when the cost of implementing the strategy is likely to exceed the income received.  This surplus cash flow is critical to the success of the strategy, as, without it, we may find that we are either unable to afford the basic necessities of life, or are forced into the position of having to sell investment assets to be able to continue to fund our lifestyle, which would result in our strategy failing to achieve the desired long term goal.

Unlike some of the other factors, such as the prevailing Interest Rate, the Capital Growth of an asset, or the Yield from an asset, all of which can be thought of as a single number, household cash flow is actually made up of a wide range of variables.

Surplus household cash flow may be thought of simply as income minus expenditure, but given the wide range of ways in which households receive and spend their money, the exercise of looking at every one of these cash flows and forming a view about how they will each change over time could become a very complex task.

This problem can be simplified by thinking about the different cash flows and looking for different items which may be expected to change in a similar way over time.  For example, some costs can simply be expected to increase in line with inflation, others may increase at a faster rate, while one cost which can be expected to decrease over time is the Interest payment on a Home Mortgage which will reduce as the Loan Balance is reduced.

One of the anomalies of trying to predict the future is that we are likely to be more conservative when assigning values to factors that are outside our control ( such as Interest Rates, Capital Growth, Yield, etc. ) and more optimistic when looking at factors which we see as being largely within our control (such as household cash flows).

Paying close attention to the expected future household cash flows, and being conservative with any assumptions made, will greatly improve the likelihood that cash flow will be available when it is needed to fund the investment strategy.

Empower Wealth’s Property Portfolio Plan includes a sophisticated Wealth Projection Simulator which allows you to model the effect of changing cash flows over time, together with many other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation.

 

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