Without exception, no one wants to run out of money before they finish their course here on Earth. It is for this reason that the Legacy Goal is a crucial input item in the planning process. Regardless of whether you desire to leave a substantial estate to your heirs or want to spend it all while you’re alive, setting the proper Legacy Goal is one of the key elements in our planning process.

On its face, the Legacy Goal is simply the minimum amount of working capital that you want to protect. But of course, there is much more to it than that. In this issue of OUR PROCESS, we would like to discuss the science and mathematics that makes this goal so important to the overall planning process.

Consider a common question we hear regarding the Legacy Goal. Why do we set the Legacy Goal so much lower than the projected portfolio values? There is a page in our Quarterly Progress Reports (QPR) that illustrates approximately 7-8 different projected portfolio values at different points in time in the future up to and including the year the plan ends. Quite frequently, the forecasted values are considerably higher than the number we establish as the minimum level of asset protection i.e. the Legacy Goal.

To answer this question, let’s use the following example as a teaching aid. Assume I invest in a security that has 999 in 1,000 chances of making $1 and a 1 in 1000 chance of losing $10,000. The probability (i.e. frequency) of making a profit is very high i.e. the number of times or frequency that we make money occurs quite often. But since we live in a world that only values dollars and not percentages, this investment must be measured in connection with the magnitude of the outcome i.e. the expectation – and that changes things.

 

Event

Probability

Outcome

Expectation

Profit

999/1000

$1

+$.999

Loss

1/1000

-$10,000

-$10

 

 

 

-$9.001

So, consider this. We win almost all the time! In fact, it seems like all we do is win. 999 out of 1000 times we come up winners. Yet, this is still a losing proposition. 1000/1000 outcomes results in a loss of $9. The reason why the probability (frequency) of profits and expectation of loss are so different in this example is because the events are asymmetrical. If let’s say we reviewed data of a coin toss (a symmetrical event), the frequency and the expectation of the outcomes would be much more similar. But guess what? The real world is asymmetrical. Furthermore, consider that in a laboratory setting, scientists/mathematicians often drop the most extreme occurrence or sample and average the remaining data.  Professors do this with grades and Meteorologists do this with temperature. But in future-casting what your life may look like, the “rare event” can’t be ignored simply because it is not likely to occur (frequency). The impact or consequence of every event regardless of how rare needs to be factored into our models.

In crafting advice to help you live your BEST life, we take into consideration nearly ALL the possible future lifetimes. We can’t simply ignore the impact of a rare event just because it is rare. And so, because we are considering the consequences of even rare events, we set the Legacy Goal oftentimes well below the median outcome in order to deliver confidence in any outcome.

This is Financial Planning done right!

Regards,

Rick Van Der Noord, CFP®

Dave Gerdt, CFP®