Why Optimism about Retirement Savings is Dangerous

Wed, Oct 12, 2011

Financial Advice, Investment

While there’s usually nothing wrong (and a lot right!) with having a positive and optimistic outlook on life, when in comes to your personal finances such optimism may not be a great idea.

No one knows this better than Wall Street executives. When the top brass fail to deliver the results that they promised — even if it was a lowball promise — the backlash can be brutal. Consider:

Financial executives know the wisdom of this approach well. When they fail to deliver what they commit to–even if it’s a low-end commitment–the resultant backlash can be devastating. For example:

Dry bulk shipper DryShips (DRYS) saw its shares drop more than 12% intraday after reporting results in late August that were significantly below estimates. In late August, OmniVision Technologies (OVTI), indicated that it expected to take in around $255-$275 million in its second quarter. Analysts had expectations of more than $300 million. Boom — just like that shares plunged roughly 30%. On a more positive note Sirius XM (SIRI) posted revenue results slightly below analysts’ estimates. However, it made up for this on earnings, which were roughly triple those expectated. The company’s shares, which had closed at $3.11, opened the next day at $3.18.

For most companies, a few shocking earnings reports won’t totally make-or-break their financial futures, and stock movements don’t always last for long. However, such examples do suggest, as Seneca and Benjamin Franklin both agree, that there’s something to be said for actually planning for the worst and then being pleasantly surprised when you’re able to beat expectations.

Promise Less and Deliver More

The best approach with financial matters is to hope for the best but plan for the worst; in other words, underpromise and overdeliver.

What does this look like in practice? Well, start with the knowledge that the stock market, over much of the past century, has averaged about 9% or 10% annual returns. But that’s no guarantee of future performance, and many expect the coming decades to feature a lower average.

When calculating what you need for your nest egg, build in conservative estimates. Instead of 10%, use 6%. Lower returns mean you’ll most likely have to save more; find out how much more. (Think of the “interest rate” as the rate at which you expect your investments to grow.)

For example, if you have $50,000 socked away and you expect to add $5,000 annually and earn 10% over the coming 25 years, you’ll end up with about $1.1 million, which might provide for a pleasant retirement. But if you expect to earn just 6%, your $50,000 and $5,000 additions will amount to only $505,000, less than half as much. Adjust your annual investment to $10,000 and presto — you can expect to accumulate nearly $800,000.

Even if you end up averaging an even lower return, by having increased your investment amounts, you’ll end up with more money than you would have originally. And if you end up with 10% returns or more, great! You’ll be able to live higher off the hog in retirement, or will be able to leave more to your heirs.

Prepare and plan for a challenging few decades ahead, and your portfolio may surprise you by growing larger than you expected. By underpromising your growth rate to yourself, you set your nest egg up to have a good chance of overdelivering.

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