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Financial modeling and heeding the warning signs

June 2012

Financial planners love the Monte Carlo simulation, so named after the gambling casino in the administrative area of the Principality of Monaco.

In Monte Carlo, known for its prominence, one can never be certain if a particular gambler will win or lose but one can be certain that, overall, the casino will never lose. This is because the games played in casinos have a slight advantage to the casino, so given a large number of gamblers - some winning and some losing - the average result will always be in the casino's favour.

Monte Carlo simulation depends on the fact that the results of a large number of individual random events will accurately describe the probability distribution of the individual event.

It may sound simple, but many of us, either on a personal basis or representing businesses, end up letting the positive possibilities sway us, rather than heeding the warning signs. The basic question should always be:  Is the financial decision I am making based on reliable information, that has been modeled and forecast, or on gut instinct?

In real life financial modeling is the construction and use of planning and decision models before making a major financial investment based on financial data to simulate actual circumstances in order to facilitate decision making within an organisation.  An individual or even an investor can create a list of pro's and con's, realistically weigh up the benefits and ask "what if?"

By engaging in financial modeling, one validates strategies prior to execution through proper forecasting, scenario building, and financial considerations while better understanding the impacts of future financial burdens.

Financial modeling helps everyone, a business leader, investor and even a private citizen to make sound business decisions and create healthy strategies with greater speed and accuracy.
Here are a few financial modeling tips:

  • Personally, get an idea of where you stand financially before making a financial commitment. Examine your financial picture: cheque and savings accounts, insurance, mortgage, and investments. Locate account records, tax returns, insurance policies, pension plan statements, and other financial documents.
  • Determine how much you have already saved toward financial goals and how you see yourself as an investor in terms of risk-taking and desired return.
  • Consider the impact liabilities can have on your financial plan. By integrating smart credit strategies, you could reduce your monthly expenses, maximize your tax deductibility, avoid disrupting a well-planned investment strategy, and increase opportunities for asset growth.
  • Paying off debt is often more of an emotional goal than a sound financial strategy. As a rule of thumb, always compare your potential investment earnings to the interest paid on borrowed funds.
  • On the business front, business leaders should begin listing and ranking financial goals, their plans for achieving them, then assess their current progress in obtaining these objectives.
    Determine net worth. Clients should prepare a statement listing their assets and subtract their liabilities with the resulting number as their net worth.
  • Set a budget.  Use budgeting as a positive tool for building financial security, for accomplishing wishes and dreams, and for making business life comfortable. The most effective budgets are short and simple. Workout a budget and stick to it.
  • It is far better to dip into savings than pay hefty interest charges on an overdraft.

Remember, even careful planning cannot take into account the unexpected

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