When Being Cautious Can Lead To More Risk

When Being Cautious Can Lead To More Risk

10 FEB  Financial Bodyguard.com

Financial planning, as the name rather implies, is mostly about the future. Yes, sometimes it can help to identify things which we should do now to make a positive change in our financial circumstances immediately but mostly it is about doing things, whether now or in the future, to help create a better future for ourselves.

In order to work out what these should be and when we should do them, we generally need to project forwards from our current circumstances. This will provide some insights into how feasible our goals are and also highlight where potential roadblocks might occur.

For example, it is all well and good to see that our resources are projected to be sufficient to meet all our objectives over the next 40 years but if we are likely to run out of liquid assets in the next five years then we might need to change something to avoid that happening.

There are essentially two elements to such a projection – the knowledge of our existing assets, liabilities, income and expenditure and the extent to which these are expected to change over our desired time horizon; in most cases this will be our lifetime.

For those of us not fortunate enough to be able to see the future with perfect clarity, the latter element will require some degree of assumption about how things are likely to develop over time.

How to derive these assumptions and what they should be are issues which absorb the attention of professionals involved in the field because, particularly over long periods, they can have a huge impact on the projected outcome even where the rates are apparently small.

For example, projecting an expenditure of £10,000 at an annual rate of 4.5% rather than 5% results in a difference of more than £12,000 a year after 40 years.

In reality, we have no idea how accurate our assumptions will be as the future is, as ever, unknowable. How many forecasters predicted the timing or impact of either a global pandemic in 2020 or a war in Ukraine in 2022?

Given the impact of getting such assumptions wrong, of which the worst could be running out of resources unexpectedly, it is not hard to see the temptation to adjust our assumptions with a view to being ‘cautious’. This might entail increasing incrementally the assumed rate at which expenditure increases and/or reducing the assumed return earned on invested assets.

However,

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