When the future is uncertain and we can’t see the way ahead, we have a choice. We can squint and work even harder to figure out the most likely path and bet on that. Or we can broaden our view to imagine a range of potential paths and make decisions knowing we’ll probably need to adjust as we move forward.
The first choice involves a forecast; the second uses “scenario planning.” Developed after WWII to help “think the unthinkable” about nuclear weapons and strategic decisions during the Cold War, the term “scenario planning” was coined by researchers at the Rand Institute in Santa Monica, who borrowed it from Hollywood, a stone's throw away.
The prime objective of scenario planning is to avoid the false certainty of a single forecast. It’s the opposite of trying to predict the future and more about developing a reasonable roadmap than fixating on a precise target.
Yes, it’s easier to proceed confidently if you think you know what is going to happen, but this also makes you more vulnerable if you’re wrong. Reportedly, the belief that the Titanic was unsinkable “was enough to keep many passengers calm even as the ship was in fact sinking.”
In developing alternate stories about the future, scenario planning helps stretch our thinking, confront hidden assumptions, and take a more flexible approach to a changing world. We’ll still be left wondering what the future holds, but be less likely to base critical decisions solely on a confident-sounding prediction.
Contemplating alternate futures is particularly helpful with long-range planning, since the future grows more uncertain the further out it extends. It’s one thing to predict tomorrow’s weather, quite another to predict it a year from now. This makes scenario planning an indispensable tool for personal-finance decisions that involve goals spanning decades.
In deciding how much investment risk to take, for example, it helps to think about the many paths that stocks might follow in coming years. When setting expectations, people tend to focus on the historical return that stocks earned - say, the 10% average return of the S&P 500 Index from 1926 through last year. But this overall average hides the variability of the Index, which was up 54% one year, down 43% another, with all sorts of results in between.
When adding or subtracting money from a portfolio, this variability can have a significant impact on growth. Depending on the order in which returns are earned year to year, the value of the portfolio could travel any number of paths:
Faced with the anxiety this kind of uncertainty produces, typical (and understandable) reactions include throwing up our hands and refusing to invest; closing our eyes and hoping for the best; or looking for a guru with a crystal ball.
Scenario planning asks us to live with the uncertainty a moment longer and “think the unthinkable” about how we’d cope with undesirable outcomes. And dream about the positive outcomes. As we contemplate the possibilities, priorities emerge, we start asking better questions, and our focus turns to decisions about the things we can control.
All else being equal, what would be the consequences of spending more or less during retirement? If markets don’t perform as well as I hope, will I still be secure? What if inflation goes sky high because of all the current stimulus programs?
Financial-planning software can quantify different scenarios to examine these questions. This helps understand the sensitivity of inputs and test assumptions. It also helps understand the tradeoffs between things like saving more, working longer, or spending less over a long period of time in retirement.
Nothing happens to the wise man against his expectation . . nor do all things turn out for him as he wished but as he reckoned - and above all he reckoned that something could block his plans.
- Roman Stoic philosopher Seneca
But the numbers are just a starting point and by themselves can be misleading. Since there’s no database for the future, we have to guess about key assumptions such as future inflation rates and investment returns. Our guesses feel more tenuous when we realize that small changes in these variables have a huge impact on cash flows extending out decades and thus the success or failure of a financial plan.
This is why my wife once threw up her hands in exasperation and said, “Why bother with any of this?” I was working my way through the CFP® curriculum and had shared a spreadsheet I’d built showing the results of saving and investing different amounts of money over time.
She quickly intuited that no one had likely ever earned a positive investment return each and every year of their lives. Even if they had, how could we know what future returns would be? As I tweaked the numbers up and down to answer her questions and we saw how wildly the projections changed, my beautiful spreadsheet began to look more like an exercise in futility or, worse, a charade.
Her question bothered me for a long time. But as I gained experience working with clients, I learned that even if we could predict the numbers to the nth degree, there was still an all-important variable that would remain a mystery: the clients themselves.
The things they wanted today would become something different tomorrow. Health and jobs and relationships would evolve, and so would they. At any given moment, the best laid financial plan could be upended not by a cataclysmic economic event or natural catastrophe, but because, well, they changed . . . their . . . minds.
Nevertheless, there was still enormous benefit in using the numbers to provoke and inform conversations about the future. During the 2008 financial crisis, a number of clients said they were able to resist cashing out their portfolios during the darkest hours because, “You told us this could happen.”
What they meant was not that we had a good crystal ball, but that we had spent time discussing past disruptive events and how similar situations in the future might affect their plans. Rehearsing the future in advance, so to speak, had given them the fortitude they needed to withstand the extreme market volatility now.
Perhaps the biggest benefit of scenario planning is how it provides an opportunity to question the water in which we swim and ask the sometimes uncomfortable questions about whether we’re leading the lives we were meant to live. Our adaptability as humans is remarkable, but it’s also our Achilles heel, since it also allows us to subsist under conditions that are adverse to our natures or interests.
Contemplating different courses our lives might take can lead us out of longstanding ruts onto better paths. In this sense, scenario planning isn’t so much about the future as about today. Combining our imagination with the best information we have, it helps us pull time forward to better care for the present, which, in the end, is all we really have.
Click here for Part I.