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.
I’m with you. I assume a flat 7% ROI and I keep a good deal of money in cash, just in case. The real reason I do it? It keeps me from feeling lousy when the market goes into a funk.
Amen, Wayne! I want to leave as little to chance as possible. If I show up at retirement with too much money, that’s awesome! More margaritas for everyone!
We err on the side of caution and aim low. With possible recessions and the costs of inflation we want to make sure we have enough. If we end up with bonus, that’s great.
Absolutely! I would hate to think of what would happen if we fell short.
Nice approach. I think I do the same thing because I try to always leave myself a cushion.
I approach it the same way. Some day I will need that money and it has meet my expectations.
Nice graph. I try to use average estimate. I don’t want to underestimate too much because I’ll have to work longer.
That’s a great point retireby40. It definitely has its down sides. 🙂
Hi Wayne, I overestimate the amount needed for retirement. As for the investment returns, I expect to do a point or 2 less than the historical norms for the assets in which I’m invested.
sounds like you’re just being conservative. Nothing wrong with that.
You arose my curiosity.
At the end of 2011 S&P 500 rose by 0,01% year -to year basis. We do have dividends and some companies paid handsome 4-5%. After inflation (3%), taxes and administration fees (2%) – you will have nearly negative outcome.
I think this year will be even worse. Few other observations:
– Only 202 of the 500 biggest companies in the United States in 1980 were still in existence 20 years later.
– On December 29, 1989, Tokyo’s Nikkei stock average reached its all-time peak of 38,915.87. Twenty years later, the Nikkei has never again reached that level — and, in 2009, reached a new low of 7,054.98.
The other thing. Lets say you manage to accumulate enough money and have $60,000 as annual income before the taxes. This was in 2010 and at average inflation rate of 5% in 20 years time you will get only $ 23,000 annually inflation adjusted.
To keep your capital protected – you need constantly top it up to protect against inflation.
How are you going to deal with all these facts?