Questioning Traditional Thinking

For many of us, when we look back, knowing what we currently know, we realize we might have planned our financial futures differently.  Looking forward though, is the real challenge.  The choices the average American has to build a successful financial future in today’s economic climate are difficult at best.  The reality is that everyone, rich or poor, must play in the financial game of life.  How they finish the game will be determined by how they play the game.  But rest assured, everyone will finish the game one way or another.  Unfortunately, over the past twenty years, playing the game has changed dramatically and traditional financial thinking hasn’t changed at all.  Think about it, what, in the last several years, has the financial services industry done to improve the financial lives of the average American?  With that in mind I believe a new thought process regarding your personal financial life needs to be developed.

SUCCESS SHOULD NOT BE BASED ON RISK

Over the past several years it has become easier to predict financial failure than financial success.  This is true because reality keeps getting in the way of traditional financial thinking.  Achieving personal financial goals has become a wicked game.  The average American understands one thing very clearly, they must live in the economy that surrounds them.  The opportunities of driving forward personal financial success are disappearing and along with that, the dreams of a lifetime.  Traditional financial thinking believes that achieving higher rates of return in your investment portfolios is the center point of your success possibilities.  But, what element of risk must you take to achieve your financial goals?  In traditional thinking, who is really the one at risk, you or the one making the recommendations?  In many ways, traditional financial thinking can be surrounded by miscalculations, misconceptions and unreasonable expectations.  

THE PREMISE

It is difficult to get to the right solution when you start out with the wrong premise.  Einstein once said, “You can’t solve a problem by using the same thought process that created the problem in the first place.”  It is important to understand that you can’t do the same things over and over again and expect different results.  In the past, traditional thinking has used the same premise when it comes to your personal financial future.  The traditional thinking premise for accumulating wealth has not changed over the past 60 or 70 years.  The problem is if you attempt to measure accuracy and success with a tool or premise that is not precise, how legitimate can the measurement be?  If, from the very beginning, the premise is flawed and the formula for measuring is incorrect, what are the chances of achieving a desired goal in the future?  Measuring your financial success is no different.

The basic premise for achieving traditional financial success continues to follow the formula that money, times the rate of return, times a number of years will result in predicting future dollars.  Although this premise is correct mathematically, over a period of time, results of this premise are hardly precise.  The premise relies on the idea that there will be a consistent flow of money, a consistent rate of return on that money and that the money will grow over a period of time.  By following this formula the hope is that you will achieve a favorable accumulation of money in the future.  This formula is the center point of the traditional thinking premise.  Unfortunately, this premise is doomed from the beginning.  It is hard to get the right solution when you start out with the wrong premise.  Here is an example of a traditional thinking formula.

 

        $200  investment a month
        x  5% projected rate of return every year
        x  40  years
        $305,204 future accumulated money

 

The premise in this example is absolutely correct.   The math is right but can you count on that three hundred and five thousand dollars and the value of that money being there in the future.  I wouldn’t.  This premise or type of thinking is centered around predicting an outcome and not planning for an outcome and there lieth the problem.  Although the example looks simple, a lot of things can change over a period of 40 years.  

First, let’s explore this example carefully.   If you actually did accumulate $305,204 over that period of time you might be able to say that traditional thinking and the premise that was used proved to be correct.  Although the premise achieved its mathematical goal, now take into consideration that during that 40 year period inflation averaged 3%.  If 40 years ago you thought $305,204 would be a good foundation for retirement, you would have to accumulate $995,586 in the future to have the buying power of $305,204.   In 40 years you will need about $305,204 just to pay the tax on $995,586.  How useful is the premise without considering inflation.

Let’s take a different look at the example.  If the $200 a month was put in an IRA or qualified retirement program and if the program earned 5% for 40 years, you would accumulate $305,204.  Now to get to this money you would have to pay taxes when you take the money out (non-Roth).  The after tax value of this qualified plan could be reduced dramatically.  Since we don’t know what the tax bracket will be in the future, let’s just assume one-third of this accumulation will go to taxes.  You would now have an after tax value of $201,434.  If you used a 3% inflation factor the buying power of $201,434 forty years from now would be $61,750.  Now how are you doing?  One should also be concerned that the premise and example we used occurred with no market losses over a 40 year period.  

Although the premise is correct there can be other consequences that could impact the overall results.  Still you need to be congratulated for any attempts you may have made in the past in trying to prepare for the future.  With the information you had at that time, you probably made the best decisions you could.  So if you receive more information and knowledge you may want to rethink some of the decisions you made in the past.  Much of the traditional thinking being used today can result in unintended consequences.