Once your company’s initial public offering (IPO) is over and the lockup period has expired (or will expire soon), the next step in your personal financial journey is to take your bearings and assess where you are financially. It’s a good time to understand the boundaries of your new financial situation and explore what’s possible—and financially sustainable—for you over the long term.
Although simple spreadsheets can be helpful in understanding your situation at a high level, more sophisticated tools are needed to incorporate the many details and assumptions required to create an accurate financial model. Because money grows exponentially, seemingly small modeling errors can have a big impact on results. As the old computer programming saying goes, “garbage in, garbage out.”
The best practice for exploring what’s possible is to build a model of your financial situation using professional financial planning software, and then use a scenario analysis to set priorities and find the limits of what’s safe and sustainable for you.
In a scenario analysis, one or more variables are changed to test how far you can go in that direction. For example, what’s the earliest date you could safely retire? Or how large a home could you comfortably buy right now? More broadly, a scenario analysis is helpful in understanding what level of ongoing lifestyle expense is compatible with reaching your big, long-term financial goals.
Listing Assets, Liabilities, Incomes, and Expenses
Building out a model of your financial situation starts with your current net worth. First, you make a list of your currently owned assets and their values, including home, bank accounts, brokerage accounts, employer stock (e.g., stock options, RSUs), retirement accounts (e.g., IRA, Roth IRA, 401[k]), college savings accounts, rental properties, and others. Next, figure your liabilities, such as home loans, car loans, and student loans.
The total of your assets minus the total of your liabilities reveals your total net worth (assets – liabilities = net worth), typically shown on a one-page net worth statement. Your net worth represents your current stockpile of money to be used for investing and spending in the future.
The next step in modeling your financial situation is forecasting your net income. This starts with your current salary and bonus income projected into the future to account for expected bonuses, raises, promotions, and potential career changes. Income from equity compensation, such as RSUs and the exercise and sale of stock options, is included here as well.
After income, next up are regular and irregular expenses. Regular expenses include living expenses, such as groceries, dining out, clothes, household items, gas, insurance, home loan payment or rent, vacation, and taxes. Irregular expenses can include new cars, special trips, big events like weddings, and other goals such as a home remodel. Funding for retirement plan contributions, special goals like kids’ college, or charitable gifts can be regular or irregular expenses and are included in cash flow forecasts as well.
The total of your incomes minus the total of your expenses gives your net income (incomes – expenses = net income). If you have a positive net income, that means you are saving. If you have a negative net income, that means you are spending down your net worth.
Most people save during their working years and rely primarily on their accumulated net worth and, to a lesser extent, Social Security or their pension to cover expenses in retirement. It can be difficult to know if you’re saving enough while working, or spending down your assets slowly enough in retirement, without more analysis.
Using the Monte Carlo Analysis
For many people, understanding how to balance saving and spending over their lifetime so they don’t run out of money is the primary goal of financial planning. One powerful technique for finding that right balance is the Monte Carlo analysis. With the Monte Carlo analysis, cash flows from net income and changes in assets and liabilities for a particular scenario are projected out through time, and investments are programmed to grow. But investment growth is not modeled as a steady upward climb, which is unrealistic and would give you a false picture. Instead, investment rates of return are assumed to fluctuate each year, as they do in the real world.
Using professional financial planning software that includes Monte Carlo analysis, many lifetimes can be simulated, with different investment returns in each year of a lifetime. To measure whether a scenario is feasible, we count how many times you didn’t run out of money over a large number of simulated lifetimes.
If you didn’t run out of money in one simulated lifetime, that is a successful trial. If we simulate 1,000 lifetimes and you didn’t run out of money in 800 out of 1,000 of the trials, then we would say that scenario has an 80% Monte Carlo success rate. In that case, you have a good chance of correctly balancing saving and spending over your lifetime—in short, that scenario works. Many different scenarios can be tested in this way to map the boundaries of your financial situation.
When you hone in on a final, working financial planning scenario to live by, Monte Carlo analysis essentially runs a stress test on that scenario by including historically observed investment volatility to ensure you will be financially secure through good times and bad. In fact, investment rate of return and volatility are critical assumptions in this process, and the Monte Carlo analysis has the added benefit of helping determine what type of investment portfolio and overall asset allocation is right for you.
Scenario analysis combined with Monte Carlo simulation techniques is a powerful tool for exploring the boundaries of your financial situation and charting a course to a safe and sustainable financial future.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. To discuss your personal situation, schedule a complimentary consultation.
