Setting financial priorities is frequently very difficult for individuals. Yet, it is very important for most people, since few of us have the financial resources to totally finance all of our “wants.”
Setting priorities allows us to consciously review our objectives and rank them as to the order of their importance to us. It also helps us to separate our “must” objectives from our “wants” or “nice-to-haves,” thus allowing us to begin the allocation of assets and cash flow toward what is most important first. This is necessary to overcome the all-too-human tendency to gravitate to those decisions that cause immediate gratification versus long-term gratification—for instance, buying a new car before saving dollars for retirement. Setting priorities prevents individuals from forsaking their most important long-term objectives for the satisfaction of fulfilling recurring short-term “wants.”
In this article, I introduce the forced choice matrix. This matrix is useful for helping with almost any type of decision. In this article, though, I am focusing on how to use it to assist you in goal prioritization and clarification, a critical step in the financial planning process. Of course, once priorities have been set, an individual must decide how to achieve those various goals. The options are often numerous, and the decision matrix introduced in this article will help in that process. However, this can be complex.
The Forced Choice Matrix
To begin, take a sheet of paper and start writing down all the things you want in life. Include every “want,” from something specific, such as a boat, to something more nebulous, such as a comfortable retirement. To assist you, I came up with a sample list:
- A new car
- A boat
- A comfortable retirement
- Funds for children’s education
- A vacation home
- Leave spouse sufficient money at death
- Braces for your children
- A hair transplant for the husband
- An entertainment center (without the frills)
- A pet dog
Next to each of these, write a number as I did in the example above. Now list these numbers down the side of a piece of paper. Next to this, create a forced choice matrix, as shown in Table 1 (minus the circles).
Work through your forced choice model and begin making choices. Start with the first two rows, working from left to right; you can see that the choices concern your first objective versus all the other objectives. You begin by making yourself choose between satisfying objective two or one, then three or one and so on. Then move down to rows three and four, which concern objective number two versus all other objectives. Remember, you must choose one or the other (this is a forced choice model).
After you have worked through the entire model, total up the number of times you chose to satisfy each objective and write this next to the corresponding number for that objective in the column to the left of the matrix.
Table 1 shows a completed matrix.
As you can see in the example, there was a high priority given to leaving the spouse sufficient money in case of death (objective number six, with nine preferences) and a very low priority given to the hair transplant (objective number eight, with no preferences).
The Decision Matrix
This forced choice model assists you in ranking your objectives relative to each other. However, it is rare that we are willing to totally give up one objective to satisfy another. Normally, we either partially satisfy both objectives or slightly modify the objectives either through requantification (for instance, saying we want $10,000 per month for retirement, then changing it to $8,000) or substitution (satisfying the new car objective by purchasing a Chevy instead of a Mercedes).
Choosing among various options can be accomplished by using a decision matrix. Again, using a piece of paper, you can draw a matrix as shown in Table 2. On the left-hand side, objectives are listed. Along the top, I have listed the various asset allocation options (for which determination will be explained later). Next to the objectives, I listed a weighting factor. This is calculated by taking the total number of objectives you have and multiplying it by the number of times that objective was chosen as a preference in the forced decision matrix. The result is the maximum number of points that you are allowed to allocate to this objective relative to its being satisfied by each asset allocation option. In the example (see Table 2), there are 10 objectives. Objective one was chosen as a preference five times in our forced choice model; thus, the maximum points available are 50 (10 × 5). This procedure is continued until the decision matrix weighting column is calculated.
From here, it is necessary to determine how well each objective will be served by various combinations of asset and cash ﬂow allocations—these are the options. For instance, if option A is chosen, it may satisfy objective one very well, but it may hardly satisfy objective two at all. Here, one must make a subjective allocation of points available for allocations being determined by the weighting factor.
In the example in Table 2, it was determined that option A would satisfy objective one very well, and so I allocated the maximum number of points available (50). However, option A hardly satisfies objective two, but does satisfy it somewhat, so I have allocated it five points out of a maximum of 20 points. You should continue down the option A column until points are allocated to all objectives, then total the points for option A at the bottom of the column.
At this point, before you can really continue, you must know how to define each option.
So, the next step is to introduce the concepts of substitution, utility versus direct value theory and objective quantification. Afterward, you will have a method of decision making that is relatively unbiased, and that will help you in setting priorities for your objectives and asset allocation processes.
Asset Allocation Options
When using the forced choice model as a method of ranking objectives relative to each other, it is rare that one is willing to totally give up one objective to satisfy another. Normally, individuals either partially satisfy both objectives or slightly modify the objectives, either through requantification or substitution.
So, I now tackle the problem of how to define each asset allocation option, so that reasonable choices can be made that will fit into your financial constraints.
Simply stated, an asset allocation option is a decision as to how current assets and discretionary cash ﬂow will be allocated in order to meet your objectives. As an example, the objective might be to purchase a new car. Option A may be to purchase a Chevy, while option B may be to purchase a Mercedes. Although we might like to purchase the Mercedes, it would mean a need to allocate greater resources to this one objective and less to other objectives. Since the Mercedes purchase would take too large an allocation of resources and could only be purchased if the other objectives are forsaken, we may decide not to choose this option. However, we may also decide we do not wish to purchase the Chevy, but instead would like to consider a Lincoln, thus creating option C.
Obviously, the entire process would be endless without some discretion. The point, however, is that multiple choices are within an achievable realistic range available. Once these choices are narrowed through the use of one’s own reasoning abilities, one can then apply the concepts of substitution (as illustrated in the auto example) and utility versus direct value to help choose the asset allocation option that best meets the objectives.
Of course, you would not need to go through this process if you were only trying to make a choice within one objective—for instance, if you simply wanted to buy a car. However, if you are in the first stages of setting up a financial plan, you will have numerous objectives and numerous options for each objective. It is this latter problem that I will tackle here.
The Theory Behind the Concepts
Before I discuss how one uses these approaches, let me explain the theories and applications of substitution and utility versus direct value. Substitution is the act of substituting one item for another. We normally substitute because we perceive a better value, lower cost or some alternative benefit by using the substituted good. In our auto example, we substituted the Chevy for the Mercedes because of cost. We then substituted the Lincoln for the Chevy because of perceived value while still meeting our first substitution criteria of cost. The opportunity and ability to substitute is what causes various asset allocation options to become available.
Additionally, we must sometimes choose between alternatives whose values are intangible (utility value) versus alternatives that have a direct tangible value. Insurance is one good example. The value of allocating resources toward payment of insurance premiums is the intangible benefit of peace of mind brought about by the knowledge that you are protected for the insured against risk. Many times, we must decide on whether to allocate our resources to an alternative with utility value (i.e., insurance, a will, etc.) or direct value (i.e., buy new kitchen cabinets, subscribe to a few new magazines, etc.).
With this understanding of substitution and utility versus direct value in mind, we can now complete our asset allocation options and decision matrix.
You will recall that previously I created a decision matrix based on 10 objectives. That matrix determined the maximum weighting that was to be given the various objectives: A higher weighting means that that objective is more important to meet than a lower-weighted objective. In the example for this column (see Table 1), these already-completed decisions are indicated in the first two columns.
To complete the process, it is necessary to study the various options available to meet the objectives. This is done by listing the various items that satisfy the corresponding objective under each option—as indicated in the table by options A, B and C. At this point, we are concerned only with the various options for each objective: Don’t worry about whether it falls under option A, B or C. In addition, it is important to list only those items that are truly worth considering to satisfy each objective—don’t list every item you can possibly think of. For instance, if you are considering a Lincoln, Mercedes or Chevy, don’t include on the list a Buick or Oldsmobile if these are not viable alternatives for you.
Next, take a look at the various options for each objective and allocate points to each item with respect to how well that item satisfies your desires. Keep in mind the maximum points allowed for each item. Also notice I have said desires, not needs (needs come into play after quantifying each item). For example, next to the Mercedes, I have written a 50; the Lincoln gets a 40 and the Chevy gets only a 15. Obviously, there is considerable subjectivity here. But you can easily see which items best satisfy your desires relative to each objective by looking at the chart and noting which item has the highest point allocation relative to each objective.
There is a cost, however, to achieve this utopia which has yet to be determined. You must now go through your table and list the dollars necessary to obtain each item. This has been done in the example in Table 1.
Now, you must go back and make a similar asset allocation table, except that this time the option A column will contain the items for each objective that were allocated the most points; this has been done in Table 2. Now, add up the costs of all option A’s. Is the total within your financial limits? Obviously, at this point, you need to know your financial limits, which are governed by current assets, current and anticipated discretionary cash flow and anticipated income streams from outside sources, such as pension plans, trusts, etc.
Most likely, your first choices will exceed your financial limits. You can now approach your decision in two ways. You may wish to proceed down column A and allocate resources to the items corresponding to the objectives with the highest priority (indicated by their weight) until all of your resources are allocated; you would then disregard the achievement of the other objectives. Or, if you are like most people, you will want to make substitutions and create a new column B so you can meet other objectives. Your new column B will list a different combination of items, within your financial constraints, to meet your objectives. In addition, you may find it necessary to create new columns—C, D, etc.—to satisfy your various objectives to different degrees.
Once completed, this chart will show you various combinations of items that can satisfy your needs based on your financial limitations. It is then up to you to decide which combination you prefer.
Once you have your objectives clearly in mind, you are well on your way to developing a working financial plan.
This article combines two that were written by Michael Leonetti for the September and November 1986 issues of the AAII Journal. At the time, Leonetti was the president of Leonetti & Associates, a fee-only financial planning firm based in Arlington Heights, Illinois. He is also a former president of the National Association of Personal Financial Advisors.