How Financial Models Trick Smart People
More Data Is Not Always Better
What if I told you that many financial models are lying to you?
This post is inspired by the Excel file I received earlier this week. It contained 12 sheets, some of them with ~600 rows.
The person who created it has a fantastic understanding of accounting and finance. He has spent decades in investment banking but fell into this trap.
It was a 10-year financial model divided into quarters. The level of detail was impressive but not useful.
1.0 More Data Is Not Always Better
Most people in the finance world are passionate about numbers and consider themselves data-driven. By that logic, having more data should help us make better decisions. This is true at the very beginning.
However, there comes a point when more data doesn’t lead to better decisions but to more clutter. At that point, more data makes decision-making more difficult.
A financial model with 600 rows looks thorough, but if it has 20 assumptions, it just multiplies potential errors. The illusion of precision tricks us into thinking that more data points equal better forecasts.
2.0 The Human Nature
Throughout our lives, we’re taught that we'll get rewarded if we do the work.
If you study and do your homework —> You’ll get good grades;
If you work hard —> You’ll get a promotion;
If you… —> You’ll get …
There’s nothing inherently wrong with that, and it isn’t new. Even the cavemen knew, If you hunt —> You’ll get to eat.
However, this relationship doesn’t always exist, and that’s what makes it dangerous.
If you spend a week building a model, you expect a reward: a thorough model that you trust because you put in the work. However, if you spend another week and make it more detailed, the model doesn’t necessarily improve.
You can divide your 10-year financial model into quarters. It’s a waste of time. You cannot forecast the capex in the third quarter, 7 years from now. Why bother? The decision to use quarters instead of a full year doesn’t make the forecast better, just more complex and difficult to read.
If used for investing, this is even more dangerous, where you can tweak an assumption to justify the time spent. Because otherwise, you’ve put in all the work, and the outcome is not actionable. If you are creating financial models for investing, you have to get comfortable that most of the time, the outcome is not actionable.
3.0 The Fake Feeling of Control
Adding 50 additional rows and splitting one unknown variable into six unknown variables doesn’t make a forecast more accurate.
It gives a fake feeling of control. In reality, it just makes uncertainty less visible.
Instead of acknowledging unknowns, detailed models can hide flawed assumptions under layers of complexity that make them harder to challenge.
4.0 The Real Purpose of a Financial Model
The goal of a financial model isn’t to be exhaustively detailed - it is TO BE USEFUL to the stakeholder(s).
Here’s how you can be better at financial modeling:
Be aware of who the stakeholders are. If it is the CEO or CFO, they don’t have time to go over 100s of rows. Figure out how to summarize everything into one page;
Before you make a model more complex, ask yourself if that is really necessary or if you’re replacing one with multiple unknowns;
Make any assumptions used transparent so that they can be tested and challenged - This allows for scenario analysis.
Any forward-looking financial model is an educated guess, and it should be treated as such.
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