Have you ever asked someone for directions and have them reply, “Oh, that’s about a mile away…as the crow flies.”
That is what you might call accurate information that is of little use. If you haven’t looked lately, you’re not a crow and you probably do not intend to fly from point A to point B.
It’s one thing to know the distance assuming no obstacles. It’s quite another thing to understand the distance, and the obstacles, so you can estimate the time lost due to various obstacles.
Let’s say you want to find out where you stand for retirement. Maybe you start off with $100,000. And you can save $10,000 per year. And you think you can earn 8%. If you do that for 25 years, you’ll have nearly $1,000,000.
At least, that’s what the math says you’ll have – as the crow flies.
But if you have to make that journey in the real world – not soaring above and over all the obstacles like crows are able to do – you’re going to encounter some obstacles. Here are a few:
1. Taxes. In a regular investment account, each year that your account values grow, you’ll owe taxes on that growth. The exact amount of the tax liability will vary, depending how the account is managed. You may find yourself paying taxes on interest earned, dividends received, and capital gains realized. That subtraction would be significant enough, but it’s even worse when you add the volatility of financial markets.
2. Market fluctuation. A common calculation error is to assume a static tax rate (of say 20%), as well as a static growth rate (we already assumed 8%, remember? Yeah, well that was a mistake – here’s why). Have you ever had a year where your investments grew at the same rate as they did the previous year and your tax liability was the same as it was the year before? Me neither. Well, if that doesn’t ever happen over two years, it sure isn’t likely to happen for 20 years in a row.
So what? The irregular nature of investment returns means that you could sometimes be called on to withdraw money from your account to pay taxes at just the wrong time (when the account it down in value). When you take money out of an investment account to pay the taxes you owe, you remove money that can never again grow. You lock in your losses when you do that, magnifying and making more permanent market down drafts.
3. Inflation. Inflation means that future dollars won’t buy as much as today’s dollars will. If you plan to save towards retirement for the next 20 years, count on just 3% inflation to cut the purchasing power of your future dollars in half.
So, when planning your financial journey, don’t leave out all the trees, stumps, road closings and detours down here on the ground that you’ll have to navigate on your way towards financial independence.
Your best tool for deciding which direction to go to avoid the most problems is a map and a guide, also known as a financial plan that comes with a financial planner attached.
