When you are estimating your future value of investments, what kind of return do you plan for? Do you aim high, hoping that the optimism will somehow lift the rate of return on your investments? Or do you try to find the market average and stick to that? What if I told you that it is better to aim low and underestimate your returns on your investments?
401k Performance History
Why Your Expected Returns Matters
Even though I am still getting the hang of investing, I have done considerably more than most of my peers. I am starting to speculate about my retirement age and have been forced to ask myself this same question. I think this is an important question to ask because how I answer it will affect my finances. Here’s why I think it matters.
If I estimate a high return, I can make one of two logical decisions:
- get really excited about my potential investments and invest more money.
- think that I will have enough money for retirement and fulfill my need to splurge a little (or a lot) on things I don’t necessarily need.
While a person’s response to their expectation may vary from person to person, it should be clear that regardless of the response, your expected return affects how you approach your finances and therefore important to consider carefully.
Why I Choose to Underestimate My Returns
When I realized why this question was important, I realized that I didn’t want to lean towards over-estimating my returns. I think this can be a dangerous position to put yourself in. You may over-anticipate a return and even if you go the route of investing more money, you could run the risk of investing too much money in something that won’t perform well at all. This could put me and my family in a difficult position later in life and I don’t want to do that.
So, the question then goes to whether I want to go with the market average, or under-estimate my returns. At first glance, the market average would seem to offer you the best route, right? It would be the most accurate thing to gauge your expected return on your investment and therefore make you better informed for how much you need to invest. There will be ups and downs, but sure the average is the best route to go, right?
Because I don’t choose individual stocks, I know that it will perform with the market average or close to it. Yet, I choose to plan my retirement according to conservative figures for two reasons. Underestimating my return leads me to invest more money. While I could plan my retirement and figure how much I should invest each month/year on the market average, I choose to use a lower % in order to give myself some cushion. I am a person that likes to play it safe. The adage, “Better safe than sorry” echoes in my mind as I type this. The second reason that I underestimate my earnings is because of the potential to win big. If I plan on a modest 5-6% throughout my working years and end up making an average 8-9%, it will seem like I won the lottery when I go to retire. A difference of a few percentage points could make a difference of hundreds of thousands of dollars over 30-40 years.
Overall, underestimating my returns forces me to be more frugal, invest more now, be prepared for a low return. I would much rather be more aggressive in the amount that I am investing now and have financial security later, than to be forced to go back to work when I am 70+.
What kind of return do you plan for?
This was a guest post by Wayne at Young Family Finance. He writes about the every day financial challenges that young families face, like the cost of owning a dog or figuring out an appropriate tip.