Monday, March 8, 2010

Risk Promotion

Whenever someone is setting a goal for retirement it will be estimation. Estimations are inherently inaccurate. The fact there are so many estimations involved in needs based planning is not a problem by itself. What makes it a problem is when people mistake the estimations for fact. As long as you remember that needs based planning is estimation you can use it as a tool to help you create a plan and a goal for retirement. However, one estimation used in needs based planning encourages risk, and can cause recklessness or complete failure. The reason this is because theoretically the higher Rate of Return someone chooses as their goal, the less they need to save. For example, if I give you the following three options in order to reach retirement which would you choose.

Option 1: Earn 8% ROR and save $400/month
Option 2: Earn 10% ROR and save $225/month
Option 3: Earn 12% ROR and save $120/month

When given the option of needing to save $400 or $120 per month, most people would choose to only have to save $120, because they think about all the other things they could do with that extra $280. They would rather have the gratification of spending their money now, and Option 3 says that they can. We already know that their ROR (rate of return) is likely not going to be a consistent 12%, but someone looking at this doesn’t know that, and the financial advisor giving them these options probably hasn’t thought enough about it. Hopefully the planner does know that this is not a promise. A 12% annualized return is a goal. And only if they reach that goal will saving $120 per month get their client to their targeted retirement amount.
The only way that they attempt an annualized 12% return is by choosing riskier investments. In some cases you can get a greater return with less risk, but in this case higher returns imply greater risk and greater variation from the targeted return. Looking back at the example of the man that retired in 1998, we can see that 10% was not manageable in that case. Those were real returns from the S&P 500. If shooting for 12% increases risk and variation, what do you think the success rate is for that scenario? If I want to gamble I will go to Las Vegas, but when it comes to the financial future of me and my family I don’t mess around. This would be unacceptable. Later I will discuss way to avoid unnecessary risk by using efficient tax strategies, controlled spending, and balanced finances.


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