You can't do any serious retirement planning or portfolio construction without making certain assumptions. But while those assumptions may be necessary, you should understand their limitations.
The assumptions in question may involve lifespan, inflation or the risk and return characteristics of investments. All of these should be educated guesses -- best estimates based on past experience and an assessment of future conditions. Unfortunately, there is a tendency for these educated guesses to be treated like established fact, especially when they are plugged into automated tools whose complexity can give the results a misleading appearance of certainty.
The truth is, as much as you need to make some assumptions in your financial affairs, over-reliance on those assumptions can prove very risky. Here are five mistakes that can lead to flawed assumptions on retirement saving.
1. Over-allocating your portfolio to higher risk investments
Financial planning projects results over very long time periods, so it tends to assume that market ups and downs will smooth out eventually, and assets will earn their expected rates of return. This thinking means there is no apparent penalty to allocating to the highest returning assets, which also tend to be the highest risk ones. The problem with high-risk investments in this context is not their short-term fluctuations, but their tendency to underperform over extended periods of time.
2. Expecting asset returns to make up for lower contributions
Essentially, people would rather see the portfolio grow its way to full retirement funding than have to make heavy contributions to get it there. This draws people toward higher risk assets so they can use higher return assumptions, but this can lower your probability of success.
3. Grasping at new asset classes
If a new type of security gets off to a fast start, promoters of that asset class will point to its return history to attract new investors. Relying on historical returns to repeat themselves is a risky business under any circumstances, but it is downright foolish when that history is limited to just a few years.
4. Holding onto old assumptions
Perhaps the best example of this is with bonds. Government bonds may have traditionally returned about 5 or 6 percent a year, but that is just not going to happen going forward with yields of 3 percent or lower. Conditions change, and your assumptions need to change with them or your retirement funding will come up short.
5. Adjusting assumptions to fit your targets
This really should be the other way around -- your targets should be based on the most likely outcomes, but people are often tempted to plug in assumption numbers that fit the targets they want to hit. This creates the dangerous illusion of being on track even though your projections are more wishes than estimates.
One way to deal with the unreliability of financial assumptions is to play the "what if" game. Though you might build your plan around what you see as the most reasonable set of assumptions, you should also calculate multiple scenarios with different assumptions. By showing you just how different the outcomes might be, this what-if testing will give you a better sense of the risk involved and allow you to do some sensible contingency planning.
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