Don’t count your chickens before they’re hatched.” – English proverb
This week I had a sharp reminder of why, when it comes to your financial health, you should never count your chickens (or spend your dollars) before they’re actually in your hand. Making assumptions about future earnings is a mistake I made many times before I got a handle on my finances and it’s a habit that I’ve put a lot of energy into breaking. However, once in a while I find myself spending more than I planned and telling myself that it’s ok because it’s almost payday or I have some extra cash coming in and I’ll use that future income to cover my current expense and it rarely works out in my favour.
Making assumptions and/or spending unearned money is something that many people do but it’s a habit that has the potential to undermine and unravel your financial stability. It takes many forms: assuming your commission cheque or bonus will be more than it is, counting on income that doesn’t materialize, basing projections on a higher rate of return that you actually achieve, to name just a few. In my case, it was a final payment on a sale that came in 6 weeks late and 80% lower than I’d expected. Thankfully, I had a back-up plan (I have learned from my mistakes after all!) but it still put a major dent in my savings goals for the year, which really ticked me off!
Related article: Disciplined spending
So, how do we minimize the impact of making assumptions when the whole business of finances revolves around making predictions and projections? Especially when those predictions can vary wildly, depending on your time frame and any number of other factors. It’s a tough question to answer because, as with many other financial quandaries, there’s no neat, “one size fits all” solution. Having said that though, there are always things we can do to minimize our vulnerability to outside forces, and identifying pitfalls ahead of time is often a good way to help us avoid them. In this week’s post, I thought I’d highlight three common financial assumptions and make some suggestions as to how we can avoid getting tripped up.
Spending Unearned Money
When you live in a society that makes it really easy to spend money you haven’t even earned yet, it’s not surprising that so many of us are still paying for stuff we’ve long since grown tired of, or don’t even remember buying. We sign up for the “buy now, pay later” deals with the best intentions of repaying the money before the interest kicks in but somehow that windfall or regular savings plan just doesn’t materialize. We buy things on credit, intending to pay for them with our next paycheque, and quickly fall into a cycle of living in reverse: paying for things we’ve already consumed rather than for our current needs.
Getting out of this cycle can be tricky. It requires cutting back expenses or boosting income to allow yourself to get caught up on past bills and then developing the discipline to avoid relapsing into playing catch up. It means recognizing the “pay now, pay later” offers and the generous credit limits for what they are: an excellent tool for boosting the sales and the bottom line of the companies that offer them. Debt is big business and, when you consider that 80% of consumers don’t pay off their balances in full before the due date, it’s an excellent way for retailers and financial institutions to profit from their customers. Don’t let yourself be played; if you’re not 110% confident you can pay for something, don’t buy it.
Assuming Higher Returns
This is a challenge that I encounter on a regular basis with clients. Statements and online tools make retirement income projections but don’t disclose the assumptions they used in the calculation. People see excellent returns in a good year and then assume that their mutual fund portfolio will continue to grow at the same rate. Projecting returns is a tricky business; every fund prospectus reminds us that past performance is no guarantee of future performance, and yet, too many people continue to assume that a 9-12% return is reasonable. It isn’t.
Related article: What rate of return should I expect from the stock market?
When you consider that the average market return is around 9% and the MER of the average bank-offered mutual fund is 2.5% then that means the highest average rate of return we should be running is 6.5% (9 – 2.5 = 6.5). If you factor in a lower risk tolerance and/or the fact that most people’s portfolio will become less aggressive as they get closer to needing their money you’ll see that average sink even lower. Personally, when I run projections, I don’t index my contribution rates and I run the returns at 3% and 5%. If someone is close to retirement, I run them at 2% and 4% and if they’re in a group plan with low MERs (less than 1.5%) and have a decent amount of time until retirement I might run them at 4% and 6%. However, I always explain that I’m assuming they’re staying in the group plan and not moving their account to a bank or financial advisor.
Related article: Low fees matter in investing
At the end of the day, the most reliable way to boost the balance of your investment account is simply to save more. Compound interest is a wonderful thing but we should never rely on it as a means to compensate for a low savings rate.
Setting Unrealistic Goals
Finally, it’s important to make sure that the financial goals we set for ourselves are reasonable. In the past, I was often challenged by the fact that the amount I think I can save is quite a bit higher than what’s realistic and, while I’m getting better, (thanks to some diligent expense tracking and a commitment to staying out of the mall) it’s a fact of life that life is unpredictable. Expenses crop up, splurges are made, we don’t track our expenses, we make unrealistic projections and sometimes maintaining that saving discipline is just tough to do. However we owe it to ourselves to try to develop a sense of what’s realistic and what’s not, because not hitting your savings goals can be discouraging and having to dip into your savings to bail yourself out can be even more so.
Related article: Setting financial goals and priorities
If you’re not hitting your financial goals then take a look at the goal with an objective eye and ask yourself if it’s truly realistic. If it is, then take an objective look at your plan (and how you’ve executed it) to see if there’s something in your planning or your actions that is tripping you up. Just as past performance isn’t an indicator of future success, so past failure is not an indicator that you’ll never succeed. Like all good things, it takes discipline and it takes time.
While I’m an optimistic person by nature, I think it’s important when it comes to finances to err on the side of caution. If we could all save more than we think we need to and resisted spending money we don’t yet have in our pocket there’s a good chance our financial future would be brighter. What do you think?