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Investing Requires Guessing

Investment planning involves a lot of guesswork — there’s no way around it. For example:

  • We don’t know what tax rates we’ll be faced with in the future.
  • We don’t know what rate of return our investments will earn.
  • We don’t know what rate of inflation we’ll have to keep up with.
  • We don’t know whether our job income will match inflation, outpace inflation, or disappear entirely at some point due to a layoff.

Yet we can’t develop an investment plan without entering something for each of those figures. End result: If the first digit of a financial estimate (how much income you’ll need in retirement, how much you need to save each year, etc.) ends up being correct, it was a pretty darned good estimate.

Online Calculators

ING recently released a site (“ING Your Number“) that seeks to tell you how much money you’ll need saved before you can retire. It gives the number right down to the dollar.

What it doesn’t give you is any information with which to judge the quality of the estimate. And I have my doubts about that quality. For example, both of the following seem like flaws to me:

  • It doesn’t ask about your asset allocation or even state what asset allocation it assumes you’re using.
  • It suggests a 7.8% withdrawal rate for a 64 year old who plans to retire at 65 and who expects to live until age 95. That’s far higher than most financial professionals or academic literature would recommend.

If you want to use a retirement calculator that gives you a ballpark figure, go for it. But if the website doesn’t explain how that estimate was calculated, it’s difficult to know whether you can trust the calculation.

Asset Allocation

Asset allocation works the same way: It’s a guess. (An educated guess, but still a guess.) That’s why, for example, all the lazy portfolios look so different.

  • Some allocate 20% of stocks to international markets. Others go as high as 50%.
  • Some use only short-term Treasuries for the bond portion of a portfolio. Others use intermediate-term Treasuries. Others use TIPS. And still others use a “total bond market” fund that includes corporate bonds as well as Treasury bonds.
  • Some recommend dedicating a portion of the portfolio specifically to real estate investment trusts (REITs). Others don’t.

But there’s no way to know which portfolio will have the best results until after the fact. (Side note: I’d be wary of any advisor or writer who claims that he does know with certainty which allocation is best.)

It’s OK to Guess

Guessing is fine. It’s unavoidable, in fact. But it’s important to recognize that you are guessing. Thinking that you have reliable figures because you got them from an online calculator or that your portfolio is bound to achieve a certain return because you read about it in a popular book sets you up for severe disappointment.

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Comments

  1. Mike, I appreciated both the simplicity and the accuracy of this article. The guessing component is sometimes called “estimating.” But they are both the same act. Even professionals must guess their inputs for their recommendations. And data has shown these analyst estimates are frequently WRONG. Good article!

  2. Bret @ Hope to Prosper says:

    The problem isn’t that people can’t guess rates of return, the problem is that they are usually too optimistic (myself included). The only things you can estimate for certain are the cost of living is going to go up and social security isn’t going to keep pace. So, everyone should probably put away more money than they think they will need.

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