The results of investing are uneven because the important parameter involves humans. Humans are emotional, over-confident and impatient. Let’s look at some routine financial literacy details and think about how the human frailties play into it.
Future capital is a function of four things. Capital employed, yield, time and tax. People measure yield but what they care about is the ending balance. That involves much more. Predictability comes at a price.
For our little exercise, I will ignore tax because, in Canada, we have Tax Free Savings Accounts. Instead of a lump sump I will use a series of monthly deposits. That is more likely to be how most people save.
Person A decides they can make 8% on their investments and will save $300 per month for 25 years. They will also increase their payments annually by a projected 2% inflation. At the end they will have about $340,000 accumulated.
Targeting 8% will tend to generate more volatility than would choosing some lower rate. People who accept volatility in exchange for yield can do fine, but most people find volatility troubling. Troubling causes them to change their approach, often at the worst possible time. Buy high because they are excited, sell low because they are afraid fails.
Targeting 8% tends to be a person who is impatient or competitive. Impatience is hard to deal with because of the way compound interest works. It will take a long time before you can see much progress. $144 gained in year one if all goes as planned. Barely over $4,000 after 5 years.
A’s sister B decides to save the same money each month but targets 6% because she does not want to have to worry. Impatience and volatility are less important to her. But at a cost. After 25 years she will have $35,000 less. So what to do?
Three choices. Save a little longer, have a little less to spend annually after 25 years or save a little more.
Save a little longer will get the same capital about 16 months later. Save $330 per month to start is about the same. Take 10% less income in future.
B is much more likely to make it through to success. There are fewer emotional hurdles and expectations are more easily attained.
The question people need to ask themselves is, “Would saving a little less be worth the risk of not completing the plan?” Even the variables are not sacred. How sure are you of your time? Would 5% longer be an issue? How much income will you require at the end, if any? Most of all, could I cope with a year that is down a lot?
Three thoughts from people who notice.
“Wise spending is part of wise investing.” Rhonda Katz. The extra $30 you need to find to get the same answer is likely easier than turmoil later.
“We’ve suffered quotational loss, 50% movements” Warren Buffett. 50% down counts as turmoil. Probably plan altering turmoil.
“Research continues to show that more people need new savings strategies than need investment planning. Most have little or nothing to plan.” Jim Ruta.
Yield matters but if over value it, you will underachieving. Explore investment and savings options, and their meaning before locking in to a plan. It doesn’t matter how you start, just how you finish. Don’t forget to retain flexibility. It is often the key to all success.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772