All financial plans and investment decisions are made on the basis of a number of assumptions and beliefs. Assumptions and beliefs are not facts. They cannot be taken for granted. With the benefit of hindsight they may be proven wrong. They may be just plain wrong and, with a little thought, can be seen to be wrong even without the benefit of hhindsight. A little time spent identifying and evaluating the assumptions that are being made (expressly or implicitly) and the beliefs held can prevent costly mistakes from being made and help identify opportunities.
Several examples can be found in calculating the amount of money a person or couple will need in order to support themselves in retirement. The calculation is usually based on the following factors (among others):
1. your life expectancy;
2. your cost of living (typically being either a budgeted amount or a percentage of current expenditure);
3. the rate of return on your investments;
4. the rate of inflation.
Each of these factors contains a number of assumptions including:
1. your life expectancy: you could live longer than the actuarial tables suggest - they are, after all, average life expectancies. With advances in medical science and some healthy living,you could live a lot longer;
2. your cost of living: many plans assume that your cost of living will be less in retirement than when working. This will not be true for everyone. Medical expenses will probably be higher. You may take up some new hobbies or travel more and so on;
3. the rate of return on your investments: most plans assume and average rate of return based on historic rates of return. This is a seriously flawed way of preparing a financial plan. An average is just that - in some years the return may be above the average and in some years it may be less than the average (or even negative). If a plan relies on draw down of capital, then below average returns (even if still positive) in the first few years can destroy the plan. Money that would have lasted 30 years if the average return had been achieved every year can run out in 20 years or less with just a year or two of below average returns at the beginning. Above average returns later on will not rectify the problem;
4. inflation: even if you believe that CPI numbers represent the true rate of inflation, why assume that your personal living expenses will rise in line with the average inflation rate? Medical expenses, rates, utility charges and travel expenses (all big budget items for retirees) have risen faster than the official rate of inflation in recent years.
As worst case example, if life expectancy is underestimated, cost of living is underestimated, the return on investment is over estimated and your personal inflation rate is underestimated, the combined effect on the amount needed to fund retirement is huge. Given that we cannot predict the future with any degree of certainty, this is one of the reasons why I have opted for a "no draw down" retirement plan.
A similar analysis can be made for individual investments as well.
One of the problems with this sort of thinking is that it can lead to decision making paralysis. It is helpful to remember that challenging assumptions and beliefs is intended to help make better decisions, not to provide and excuse not to make any decisions at all.
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