banking and economics
what do you assume?
WSA adsense code -->Question everything.
I often do rough calculations on all sorts of personal finance topics. Most of these require some assumptions, and I tend to use the same assumptions all the time. But you should never take anything for granted, maybe my assumptions need to be questioned.
inflation
If I need to use an actual figure, I generally choose to assume that inflation will be at or around 3% indefinitely. I pick 3% because that’s the target rate that has been set for all of my adult life. This figure is more a guess than anything that I firmly believe in, because I my other assumptions tend to be explicitly dependent on inflation.
savings interest rate
If I’m doing a normal calculation, I assume that the current *best* savings rates will continue for the forseeable future. I don’t think this is actually accurate, but I think that it’s good enough for the short term, and its not normally a major issue if it is slightly out.
In a more abstract way, I always assume that savings interest rates will never really fall below the inflation rate. Or rather, that it will always be possible to earn interest on cash that beats inflation, although it may take a little work to find the best deal, especially when tax is taken into account. Part of the reason that I think this is as a kind of loose interpretation of efficient market theory.
wage inflation
For the last 30+ years wages have gone up at around 2% above the rate inflation (we really are better off than we used to be). Technology improves and processes get more efficient. I think this is likely to continue in the long term, but I’m perfectly willing to accept this may turn out to be wrong. I more firmly hold that my own wages will be increasing at around 2%-5% above the rate of inflation for the first 10-15 years of my career, and fully expect them to stagnate more after that point.
house price inflation
I live in the UK which has been experiencing cyclical boom-bust housing market nationwide for years. I assume this will continue for the rest of my natural life. But the UK is also one of the most crowded countries on the planet, we have restrictive planning laws, and the increase in the number of households is greater than the increase in the population - I also assume that this will continue into the very long term.
Based on all these things I generally assume that house prices will (only on average) increase at above the rate of inflation and generally hover around the rate of wage inflation in the medium to long term.
stock market returns
I usually use a reasonable estimate of 4% above the rate of inflation, because this is the figure that official estimates for pensions and the like use. I have absolutely no other rationale for this, other than that I expect it to be generally at or above the rate of inflation. Stock market returns are always assumed to be average annualised returns over a suitable long term.
Similar Posts:
- inflation is good…sometimes
- mulling over negative equity
- overpaying the mortgage or investing for retirement part 1
Discussion
9 comments for “what do you assume?”
Post a comment
subscribe
use a reader
Hopefully wages continue to increase above inflation, although there are rumors we may be in for a high inflation increase soon. What do you think?
Charlie Munger, the sidekick of Buffett at Berkshire Hathaway, has an interesting spin on this — he says you should ‘always invert’.
So for instance, if you think rates are going to fall, think what would happen if they went up.
It’s not just to check your thinking, it also gives new insights into the outcome you do think is most likely.
This post made me laugh, not because it isn’t wonderfully sensible…but because I recently had a conversation with a friend about something similar and she said
“I assumed I would marry a rich husband”
that she did!
Maybe that’s an assumption I should start making?
Your assumptions seem pretty reasonable. In academic circles folks suggest that the equity premium (the long term average return on stocks compared to risk free bonds) is about 6% or so. US treasury bonds are typically taken to represent the risk free rate. SO - the bottom line is that I think your expected return on stocks is higher than you assume.
The one assumption that i make is that everything is cyclical, what goes up must come down, what is down, will eventually rise: interest rates, savings rates, mortgage rates, market performance..
That way i don’t panic or get too complacent in financial matters..
@Shadox:
I’m not sure whether the expected return on stocks is likely to be lower in the UK, or that the expected return used for standard investment projections in the UK is actually assuming a mixed portfolio (some stocks, some bonds?). If my expected return on stocks is actually higher than I think, that probably shouldn’t be a bad thing - for personal practical use, being able to retire early is probably not going to be a disaster
Hmmm…. I operated for many years on a set of very similar assumptions. Now that I’m on the verge of retirement, none of them are any good. Lucky for me I didn’t retire when I really WANTED to retire (and at the time could have), so was still employed when everything crashed around our ears. Now if I just don’t get laid off and I can just hang onto my health and my job until I’m 70, maybe I’ll be sort of OK in retirement.
I no longer assume anything.
@Funny about Money:
Yes, the really important thing about the assumptions is that most of them only work for the really long term, but as we get closer to retirement, we have less time for things to sort themselves out. I’m not sure how and when we should be transitioning to much more conservative assumptions.