While most people can be financially free, many don’t reach there. My earlier article spoke about 2 reasons (that I have observed, there would be more) – Underestimating the long-term and lack of direction. Today, lets understand how people underestimate the long term (and possibly why).
“Humans are terrible in predicting the future. We really overestimate what we can do in the short term and underestimate what we can do in the long term… If we can glimpse even a couple of years into the future, even that’s difficult to do” – Bill Maris
Underestimating the long-term is key to understand, since it is a weakness in the way humans think. We are used to thinking linearly whereas events in life have exponential effects – both on the upside as well as down. While the above quote originally alluded to technology driven evolution, it equally applies to the effect that money decisions can have on one’s future.
The upside impact of time is fairly straight-forward and I will not elaborate much on it as most of you would know it – the effect of compounding over time on money. Suffice it to say that this is like a lottery that you have a near-guaranteed chance at winning, the only condition being to start early. A common example that many mutual funds show to promote starting SIPs early goes something like this.
- a SIP of Rs 10000/month from age 25 to 35 (10 years) creates a corpus of Rs 4.60* cr at age 60 (ie. Start early with a sum at age 25, invest for just 10 years)
- a SIP of Rs 25000/month from age 35 to 60 (25 years) creates a corpus of Rs 4.74* cr at age 60 (ie. Start just 10 years later, but with 2.5x the sum, invest for 25 years)
* (12% pa rate of return assumed in both examples, monthly compounding)
On the other hand, the downside impact of time is not something that is understood as freely. Here, there are 2 impacts that one needs to watch out for, namely Inflation and asset mix.
As we already know, Inflation reduces the purchasing power of your money, and therefore you need more every year to maintain the same lifestyle. Importantly, lifestyle inflation (which is what impacts us) is also a few percentage points higher than the headline inflation that is reported.
What this means is we do not readily understand the sums of money that we need for events/expenses that are beyond a few years ahead. Let me share a recent customer conversation. The customer is nearing 50, and has 2 goals, one short term (daughter’s marriage 3 years away) and the other a bit more into the future (retirement at 60).
His initial estimate for the cost of the marriage was fairly accurate. He estimated a requirement of Rs 70 lakhs 3 years from now, considering a current cost of Rs 50 lakhs. At an estimated lifestyle inflation rate of 8%, the required amount is approx. Rs 63 lakhs, hence not very off the mark.
But when it came to retirement, his estimates were way off. Basis his current monthly expenses (only him and his wife) of Rs 2 lakhs per month, he estimated that by age 60, he might need about Rs 3 lakhs. While intuitively this seems ok (a 50% increase!), when one looks at the effect of inflation on it, it is very inadequate. Assuming a lifestyle inflation of 8% per year, the sum required 10 years ahead per month goes up to Rs 4.32 lakh!
Remember this is nearly 44% higher than his estimate, month after month, for an entire retired life, of maybe 25-30 years. An underestimation like this proves very costly for retired people, needing them to make drastic changes to their lifestyle, at a difficult age, to sustain themselves.
A connected but important effect of underestimating the long-term is having an adequate corpus, but with the wrong asset mix. A real-life example occurred recently with very close family friends who came to us for advice.
While the retired couple were reasonably secure financially, the bulk of their assets were in real-estate, gold and fixed deposits. Their cash-flows were in control currently, but in a couple of years from now, they would have had to start breaking their deposits for monthly expenses, and were projected to exhaust them in about 8 years, leaving them with assets but no cash.
While these assets are safe, they are both illiquid and not necessarily inflation-protected. While real estate may protect inflation to some extent, important to remember than it has the disadvantage of not only being very illiquid, but also stops appreciating at market rates once the house is more than 20-30 years old.
The effect of time on money can be deleterious if not estimated properly in time and necessary corrective actions taken. Hence, underestimate this risk at your own peril.
Finwise is a personal finance solutions firm that helps individuals and families plan for their financial goals, follow their passions and achieve financial independence. For consultations, please reach us at firstname.lastname@example.org or +91 9870702277/9820818007.
Image credit: Jack Sharp on Unsplash.com