Numbers don’t lie! Advice can be verified

The numbers don't lie

When you visit a financial advisor and receive advice, are they sharing their opinion or facts? Many people think they are relying on a subjective opinion when they seek financial advice. The fact is that you don’t have to take this leap of faith. I can prove why a certain approach or strategy is the most appropriate and effective using simple math. The beauty of this is that numbers don’t lie. You can trust the math.

‘Why’ is often more important than ‘what’

I have many clients that I have dealt with since I started this business in 2002 that trust me 100%. These clients are only interested in the ‘what’ i.e. what should they do next. However, if you meet a new financial advisor, I suggest the ‘why’ is more important to understand. Having the advisor explain why a certain strategy or asset class is the best solution for you often provides an insight into their way of thinking and how robust and rigorous their advice methodology is. What’s more, if the advisor can prove it to you using simple math then it should go a long way to building your confidence in them. Let me put that a different way. If an advisor cannot explain why they have recommended somethings and in most cases, prove it using math, then you probably should be concerned.

Take a recommendation like you should invest in property. It’s not because I think property is a better asset class, or because I think the property market will continue to appreciate, or because I think you will enjoy a better overall return. It is none of these things. No. I recommend property because I can mathematically prove that it’s the best tool for the job. Much like a golf player knows that teeing off with a putter (not a driver) isn’t the right club for the shot – that’s not a matter of opinion – it’s a provable fact.

The foundation of any investment strategy is rooted in numbers

Financial modelling is the foundation of any investment strategy. A financial model is simply a spreadsheet that projects forward your assets, liabilities and cash flow – often through to retirement and beyond. Advisors use a financial model to achieve two main things:

  • It will prove (or disprove) that a financial strategy works i.e. achieves lifestyle and financial goals. How much do you need to invest in the next 10 years (and where) to achieve financial independence? A financial model will help answer this question.
  • To compare various strategies to determine which one is the most efficient. Is it better to invest in two properties and consequently contribute less into super, or should you invest in one property and maximise super contributions? Undertaking some financial modelling will help answer this question.

A financial model is a little bit like a road map. When you leave home and you know where you are heading, your cars satellite navigation will work out the quickest route to your destination. This is the role of a financial model in the planning process.

You can download an example of a very basic financial model here (scroll to the bottom of the page).

Accuracy is important – shortcuts can cost

When ProSolution launched its financial advisory service back in 2008, we quickly realised that the off-the-shelf financial modelling tools that were commercially available in the industry didn’t accommodate direct (investment) property accurately enough. I guess this isn’t surprising given the market was/is dominated by commissions-based planners that typically recommended (sold) managed funds, not property. A financial model needs to account for things like land tax, compression on rental yields over time, use of various loan structures and offset accounts, various ownership structures and so on. Therefore, we invested a lot of time and money to build our own proprietary financial model that perfectly accommodates all asset classes including direct property.

The underlying assumptions are key

A financial model is only as good as the data that is fed into it. Arguably the most important inputs are the assumptions. As a general rule, it is best to be conservative with your assumptions but not so conservative that it starts to become meaningless. Conservative but realistic.

Here are some of the key assumptions that I use when planning:

  • Inflation rate of 2.5% p.a.
  • Mortgage interest rate of 7% p.a.
  • Investment-grade investment property capital growth rate of 5% + inflation (this might be adjusted depending upon the grade of the property). I adopt a lower rate for a home and non-investment-grade property
  • Share/bond market portfolio returns of between 6% and 7% p.a. (comprising of 50% of income and 50% of capital) – but this depends on the asset allocation i.e. split because growth and defensive assets and might be adjusted up or down
  • Income tax rate brackets are adjusted for inflation

Strategy trumps tactics

Tactics refers to what to invest in whereas strategy refers to how to invest. Imagine starting to build a house without any architectural plans? Or leaving home on a road trip without a destination and map? You just wouldn’t do it. So then why invest hundreds of thousands of dollars without a clear, well thought-out strategy?

Developing a financial strategy doesn’t involve smoke and mirrors. In truth, its foundation lies in simple math. Virtually all financial mistakes are preventable and predictable. Almost no financial mistakes are the result of just bad luck. A financial model can do a lot of the work in helping you to avoid making costly mistakes.

To learn more about why a financial strategy is important, watch this video. And if you would like to watch the other four videos in this series, go here.