Forecasting

Something i probably devote as much time to as the basic managing & recording of my monthly finances is forecasting & planning, and i find this has a variety of uses.

Whilst this is inherently more judgmental and speculative than the actual reporting of past events, it allows me to project what my financial position is likely to be in the coming months or years.

Looking a few months ahead (for example the months of 2013) is particularly useful in managing the timing of cashflows, such as one off income/expenses or investments. It also helps the goal setting process & performance evaluation, in determining a baseline ie. estimating my financial position at the end of the year if nothing significant or out of the ordinary occurs in the coming months.  Looking further into the future can help to plan for major life events or expenses, or even potential retirement scenarios.

Whilst it is generally easier to forecast a short distance ahead, i believe the key to this process is determining appropriate assumptions upon which to base the projections.  Short term (for example within 1 year) assumptions are generally straightforward as income streams may have greater certainty, and expenses are either likely to be recurring or predetermined such as holidays.  Long term assumptions should ideally take into account the impact of inflation (certainly on expenses, and hopefully on income!) and investment returns.

Generally i like to keep my assumptions as simple as possible.  Given the inherent uncertainties in looking ahead, i see little value in over-engineering the process and losing sight of the key messages and purpose. For 2013 i've projected income & expenses to be broadly similar to 2012, with conservative investment returns.

My long term forecasting assumptions are very simplistic, really to keep my workings as simple as possible. For example, rather than trying to inflate both my income & expenses, i leave them both flat, effectively assuming wage inflation would offset expense inflation.  As my income generally exceeds expenses, i believe this generates a fairly conservative result, and is also easier to interpret (everything can be read in today's prices).  I often consider attempting to inflate these up and probably will do in the future, but for now i'm quite happy running a simple model. This is also because my primary focus for now is in managing cashflows and investments over the next year or so.

I'd be interested to hear if anyone takes similar or different approaches to forecasting, and what assumptions are used.