Ignore the headlines, focus on the fundamentals

So much has happened over the last 18 months and the rate of change seems to continuously accelerate. It is so easy to get caught up in headlines, certainly within the economic sphere among many others. These headlines can cause confusion, prompt questions, and cause many people to feel uncomfortable about the future. Will inflation become structural? Is the market too high? What happens if the market has a correction? Have I saved or am I saving enough to outpace the rising cost of living? These questions are normal, natural, and relevant at any stage of life and during any phase of an economical cycle.

Cash flow and net worth modeling are important tools to providing perspective on where you are right now, and how you are trending. I find when we go through this modeling with people the result is always a higher level of comfort and peace of mind. The peace of mind is not necessarily driven by a rosy picture, but it does stem from a high level of certainty, good or bad. Put another way, knowing how things are trending versus not knowing will always provide more clarity and confidence, even if the trend line is negative and needs to be improved upon.

Financial planners always use a series of assumptions in their models, those should always be conservative. That doesn’t mean one’s investment portfolio or cash flow strategies should necessarily be conservative; the assumptions should always be on the low end so that you are doing everything in your power to maximize your chances of success in the long run. The longer the time period, the greater the margin of error, and thus care should be utilized when providing this type of analysis.

So, what are some of those key conservative assumptions?

Inflation – I would recommend using 3% as the number.  Over the last 25 years the inflation rate has average more like 2%, and the Bank of Canada and US Federal Reserve have indicated that their target is to work to keep inflation in the 2% range.

Rate of return – I would recommend no more than 5%, even with an 80%+ equity portfolio. If your portfolio is below 50% equity, consider using 4% as the long-term rate of return. Keep in mind these are just assumptions and should not be confused with the expected rate of return of a given portfolio.

In other words, the projection should be showing a return of 1-2% net of inflation. Even in long bear markets with the income flow from a portfolio this should be achievable.

Market Values – if you are concerned with the current level of the market, run an analysis that assumes your portfolio values are just 80% or 90% of what they are now. In other words, if the market corrected 30%, and you are down 20% (because you have a 70% equity portfolio for example) – use those values as your assumption going forward. Keep in mind at the bottom of a correction it’s probably far too conservative to assume 5% return going forward after that given equity markets have a long-term average of 9-10% including corrective activity.

Expenses – the first step to making an assumption is knowing what your actual expenses are, both core and discretionary. I have written about this in the past; many people struggle with this because it is tedious, but it also shines a light on things that might need improvement. Many also feel if they track their expenses that they effectively put themselves on a budget – this is not true. A budget may be required depending on the circumstance but knowing what your expenses are is not the same thing as putting limits on those expenses. Whether you are acting as the CFO of your finances or we are, the CFO needs to know what the expenses are. Once you have this number – consider boosting it 10% for assumptive purposes and keeping those expenses consistent through the later years. We often see people’s expenses reduce significantly once they are past age 80, 85 or 90, but assuming they don’t, to account for unknown retirement home living expense, elder care, etc. will provide for more confidence in the end result.

Life Expectancy – while many people have an expectation of how long they will live, I would suggest you project out to age 95 or age 100. While none of us know our ultimate expiry date, you wouldn’t want to plan for 85 only to need significant income for another 10-15 years.  Age 100 may seem unrealistic, but it is certainly on the conservative side in terms of planning for the future.

So…if you have a recent analysis where you assume a 1-2% net of inflation return, expenses staying the same for life (increasing with inflation), living to age 100 and possibly incorporating some of the other conservative assumptions we discussed, and that model looks positive and healthy with money left over at the end – you needn’t worry about whether the market is high and whether inflation is transitory or structural.  Clarity, confidence, and peace of mind – things we all need in periods of great uncertainty.

If you haven’t gone through this analysis lately – perhaps it’s time.  I hope you enjoy the rest of your summer.

~ Rajeev