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Why the Second Law of Thermodynamics Matters in Financial Planning

 January 19 2017     Anna Pfaehler

The second law of thermodynamics states that the state of entropy of the entire universe, as an isolated system, will always increase over time – or things fall apart.

Harvard Professor Stephen Pinker recently wrote for Edge.org:

“Not only does the universe not care about our desires, but in the natural course of events it will appear to thwart them, because there are so many more ways for things to go wrong than to go right. Houses burn down, ships sink, battles are lost for the want of a horseshoe nail. Matter doesn’t spontaneously arrange itself into shelter or clothing and living things don’t jump onto our plates to become our food. What needs to be explained is not poverty but wealth.”

Wealth does not just happen. In order to build a nest egg, we must intentionally save and conscientiously forgo the instant gratification of spending all our income in pursuit of future goals.

Furthermore, it does not suffice to just build wealth. It must be maintained or else it falls apart.

Legislation changes limit or expand the set of actions available to us. In recent years we have seen changes to Social Security that have required retirees to revise their intended filing strategy. This year we may see changes to the income and estate tax systems which would cause many to reconsider their income tax and transfer tax planning.

Our personal situations change as time marches own. Marriage, divorce, births, deaths, illness and recovery all can change your priorities. As your financial goals change so too must your strategies for achieving them.

Market returns are unknowable in advance so we position portfolios to the best of our ability given the information we do have. Ultimately some assets will outperform others and the portfolio will need to be rebalanced to bring it back to its target allocation. Sometimes the target itself will need to move as your financial goals develop.

In our planning, we run Monte Carlo simulations on clients’ retirement cash flow projections. This allows us to model how volatility in the markets can affect the success of a retirement plan. One of the shortcomings of this simulation is that the client’s plan is static regardless of whether or not the world is ending. However, in reality we are able to adapt and change. We can right the course when life has interfered with our assumptions. 

The New Year is a perfect opportunity to revisit those assumptions to ensure your planning makes sense in light of an ever-changing world. If you pay attention, you can catch and quickly mitigate risks that could scramble your nest egg.