We are in the business of helping people manage their financial resources to achieve their varied goals, many of which are years or even decades into the future.
But how can we predict a future yet to unfold? Here are some of the tools in our toolbox:
- Look to the Past – It’s true: past performance does not guarantee future results. Over a 30-, 40-, and even 50-year investment horizon, however, asset classes (e.g. large company US stocks, corporate bonds, etc.) tend to provide a repeatable rate of return. Why? Because in order for investors to assume the risks of long-term investing, they expect to be compensated for the uncertain result and for enduring the ups and downs of investment prices in the interim.
Since 1926, large capitalization and small capitalization stocks have provided annual compound returns of nearly 10% and 12%, respectively. Investment grade bonds have returned almost 6% over the same time frame.
By understanding historical returns for each asset class within a diversified portfolio, we can begin to formulate a conservative and reasonable return scenario that we use to project how fast your investments will compound over time. A similar method can be used to estimate inflation, a measure of the rate at which your expenses will increase over time.
- Set Specific Goals – As individuals, we often have a conceptual idea of what we’d like to achieve, but frequently our notion of what it might cost to make that goal a reality is vague and uncertain. While it may seem intuitive, formally identifying and quantifying one’s goals is essential to formulating a plan to achieve them.
- Understand Your Habits Today – We all have financial habits, whether spending and savings tendencies, behavioral reactions to good and bad markets, or responses to changes in our financial resources. Expectations of financial needs in retirement largely originate with you, and those expectations are often shaped by the person you are today. Understand your relationship with money at this point in your life, and you will gain great insight into how you will answer questions like “How much do I expect to spend each year in retirement?” Only then is it possible to understand if savings today will provide enough for a desired lifestyle tomorrow or, conversely, if something needs to change.
- Reevaluate Regularly – Abraham Lincoln once said, “The best thing about the future is that it comes only one day at a time.” The simplistic brilliance of this statement is central to the financial planning process. As the future unfolds, the variables affecting a plan become more concrete. Changes to Social Security, tax rates, or income levels are just a few factors. We simply know more of the answers as time passes. After a plan is initially created, it must be updated as the future moves from beyond the headlights to the rear view mirror.
We hope this post helped shed some light on how we plan for a foggy future. Check back in two weeks for our take on using your home as an asset.