Portfolio Assumptions That Can Harm Your Financial Planning
The accuracy of your financial plans is a huge determinant of how your life will be post-retirement. To plan with precision, you need to make certain assumptions, some driven by facts and others based on cautious judgment. However, in both scenarios, the assumptions need to be as close to reality as possible for financial planning to stay put. Both extremely negative or highly positive postulations can harm the future. Hence, while making your monetary plans, it is important to evaluate each aspect and be wary of some specific mistakes which most people are likely to make in their investment portfolios.
Here are some portfolio assumptions which can severely harm your future financial planning:
1. Life expectancy
It is natural for a person to reject or not give due importance to the subject of their death. However, as harsh as this sounds, it is also something that cannot be ignored or avoided. The sooner you accept the reality and frame plans in accordance, the better the future you can have. While investing, most people need to make assumptions about their life expectancy, i.e. how many years do they expect to live? Here is where, most often, financial mistakes are made.
Many a time, people make assumptions without any reference to facts. The biggest setback for a financial plan is to outlive it. If you are in your 30s and make investments assuming that you would live for at least 50 more years, you may suffer economically in case you live on for another five or ten years. It is also worth noting that those are the years when you will need maximum financial support to cover medical expenses.
On the other hand, if you expect to live until the age of 90 and save accordingly, but die at the age of 70, then all your saved money is of no use. Hence, life expectancy assumptions can seriously harm financial planning, if not made with proper data considerations such as life expectancy averages. As per the records of 2019, the lifespan of an average person in the U.S. was 78-79 years, which is a 0.08 percent increase from 2018. Your parents’ and grandparents’ ages and health can also help you determine your life expectancy.
2. Contingent assets or inheritance
Another grave mistake that you can make in financial planning is relying heavily on contingent assets or inheritance. As per the general tendency, people arrive at the sum which needs to be invested by factoring in their real assets. Typically, a person who is in their 40s and wishes to retire at the age of 65 will assume that he/she needs funds equivalent to the target minus the worth of real assets such as a 401 (k) account, an individual retirement account, etc.
However, it is important to note that only real assets can be relied upon and no contingent assets or expected inheritances form any substantial ground. If a person expects to receive contingent assets – such as a high-end bonus, in cash unvested stock options, or be passed on a piece of the family inheritance – and makes the investment plan accordingly, then the financial planning is most likely to suffer a setback. Contingent assets and inheritances are not guaranteed security, and incorporating their value into the financial plan is a huge mistake. Additionally, not receiving the said sum can cause the plan to fall short and eventually lead to a monetary crunch. Moreover, given the increased life span, rising health care costs and long-term care needs, there may not be much inheritance left to be passed on. Thus, it is wise to count and know the worth of your contingent assets and inheritance, but never add it to your savings for the future as they are unreliable assets.
3. Impact of inflation
One assumption that can make or break your financial future is calculating inflation. Inflation refers to the general rise in prices and the eventual fall in the purchasing value of money. Inflation is a hard truth, and you cannot close your eyes to the damage it can cause if not factored in appropriately. To illustrate this simply, suppose there is a 40-year-old man who wishes to buy a house on retirement at the age of 65. Currently, the house is worth $2 million. Hence, the man starts to save and invests in a manner to be able to amass $2 million. However, upon retiring (25 years later), the value of the house has increased by 3.5 per cent annually, and the property is now worth almost $4.7 million. In this case, the financial plan failed because the man did not factor in inflation. All investors must be wary of this mistake and should make all investments and portfolio adjustments only after considering the rise in future prices and a decline in purchasing power.
For this purpose, assumptions can be made by accommodating the CPI value. CPI – consumer price index is the most common statistical measure of inflation and one which can help you make your financial plans with much more accuracy and ease. Typically, an inflation rate of 3.5 per cent must be considered for personal expenses, while an inflation rate between 5 to 7 per cent should be measured for education and medical expenses. Additionally, all portfolio investments should include stocks and assets, that can potentially outgain inflation in the long run.
4. Working years
Lastly, a special mention for a very common mistake that can ruin your financial planning is expecting to be working past the age of official retirement. Even though working after the age of 65 has a lot of benefits such as more savings, delayed Social Security benefits, delayed withdrawals, etc., but it is more of a dream than a reality for most people. The future is highly unpredictable, and even though you might want to keep in mind the best possibilities, it is important to remember that tomorrow will not be the same as today. Also, over the years, as you mature, your desire to work will eventually reduce, which will be fueled by age limitations and other uncertain factors. This implies that there are very few chances that a person might be working beyond the official retirement age.
However, if financial planning and investments have been structured considering a long working life, then there will be a huge fallout in the plans when the person retires before planned. If you plan to work even after 65, your savings will be dependent on this assumption and time frame. However, by the time you are 55, if you wish to retire early, you will not be able to do so because you will lack enough funds to last your non-working years. Hence, it is advised to be cautious and prepare well, keeping in mind all possibilities.
To sum it up
It pays well to be following a balanced, conservative approach in financial planning. Assumptions which are made incautiously, often negatively impact the portfolio’s worth in the long run. You must be watchful and rational, and make as many realistic and fact-based considerations as possible. You can also seek help from financial advisors whenever in need.