Overestimation Versus Underestimation

Kelly McKernan - Illusory
Illusory by Kelly McKernan
I was recently reading about long term goals and some other peoples planned journeys to financial independence over at Frankly Frugal Finance and Big Guy Money. They had some fairly detailed analysis of what their long term goals were, going out 15 to 25 years even. While I have gotten out the spreadsheet from time to time and plugged in numbers and calculated out 10 years or so I've never really put much weight into it.

Every year for the past 4 years I've put down a financial goal for myself. I get the balances of all of my accounts, tack on a percentage rate of how much I think it will grow, add in how much money I expect to add to that account myself, and then tack on a smaller percentage rate of how much my new money will grow throughout the year. Each year I seem to get more and more detailed with this because each year I find that my estimates are significantly off. Every year, including this one I have beat that initial goal. But I shouldn't get ahead of myself yet, the market could tank before the year ends and I have a significant vacation coming up that will not be cheap, either way, unless something major happens my financial goals for the year look like they have already been achieved.

The main reason I'm off is because of stock market returns. The market has been very kind to us in the past 4 years so I never plan for the market to grow by over 20% like it did last year but it's a nice bonus when it does. Since every year I seem to beat my goal, each year I make it more aggressive. But I know that this bull market can't keep going for forever, so one of these years (possibly very soon) the market won't do well and I will fall short. Maybe I'm a pessimist, or perhaps I've been listening to all of the gloom and doom warnings about how the market can't keep going up like this forever, but I'm guessing that next year I won't be so lucky.

But all of this got me thinking about why we might overestimate or underestimate our goals and what that might say about the person making them. In the business sense of things this may be easier to measure which route you should take:

Reasons for and against Overestimation

  • Having longer timelines will generally relieve stress from the project/task
  • Parkinson's Law is the idea that a task will expand to fill the time given, so if you give yourself too much time you will find a way to fill that extra time.
  • Another concern is Student Syndrome, where if a student is given too much time then they will procrastinate and start the project late.

Reasons for and against Underestimation

  • Shortening the timeframe will instill a sense of urgency, if I think something will take 8 months to complete but I give myself 6 months, even if I complete it after 7 months I have beaten my original prediction, and at worst case it might take as long as I originally thought.
  • low estimates can lead to poor planning because you will have to make new assumptions based on a shorter timeframe. Poor planning in the initial stages of a project can cause bigger problems and redesign of plans later on.
  • Less time to complete projects will lead to higher stress and over long periods of time this can reduce the quality of work and lead to burnout.
  • Once a project is late there is often lots of re-evaluation of new timelines to determine when a project will be completed and more status meetings to make sure things are on time. Lots more effort goes into checking in on the project which distracts from actual work on the project.

In the business sense of things this is much easier to weigh, typically you should go with what will cause the least amount of consequences. If you underestimate and cannot get your product delivered on time that could cause you lots of money. At the same time if you overestimate you could waste money on development time that might not be necessary. When there's monetary values that you can extrapolate from each outcome it becomes clearer as to how you might want to plan. For the most part underestimation causes the most problems and should be avoided.

But personal finance is a little different than the business sense of things. Personal savings goals do not affect anyone besides the person making the goal. Stress of meeting these goals should also not be a driving factor because hopefully you're planning to be financially independent much earlier than before you turn 70 and can no longer work.

I think that aggressive goals are good to push someone to do a better job than the normal person would, but if you look out long term than you may end up disappointed when you fall short of these goals. On the other hand if you underestimate your goals then you may end up happily surprised when you reach that goal much quicker than you originally thought.

Personally for my long term financial goals I think I am overestimating by thinking I will be financially independent by 45 but I'd rather be prepared mentally to work until then rather than wait until I'm that age then realize I have another 5 years or so before I can really quit a job that I have no passion for.

When planning my annual goals I have been trying to be aggressive with them just to push myself, and next year I may have to set even higher goals for myself so I don't beat them months before the year is over. But I also think that next year we will hopefully be do for a market pull back, I say hopefully because I think that on occasion that's good for the economy, if we get to far ahead of ourselves then suddenly we have a market crash, and I'd rather have a handful of corrections over a major market crash.

Overall I think goals should be flexible and re-evaluated as needed. Looking 10 years down the road is nice to imagine but at most you can only get the broad strokes of things. Life is too unpredictable to know what to expect. I don't even think that my annual financial goals will ever be close to accurate. If they were accurate then I would probably be able to predict the stock market a little better and we all know that's not possible.

So how do you assess your goals? Do you overestimate or underestimate? Do you intentionally choose to do that, if so, why?

9 comments:

  1. Hey Zee, Thanks for the mention!

    Oh man, this is a post by itself! I'm sure you noticed in my rundown that I only gave % of savings, and not dollar amounts. I actually kind of backed into this Financial Independence thing.

    I've always been a spreadsheet guy and when I started getting interested in finance, I began building a custom spreadsheet. I made safe assumptions like a lower pay increase than I've ever gotten at my job, what I thought was a good, long-term rate of return based off our asset allocation, then threw it in a compound interest sheet.

    What took me aback is I had originally projected out to 'normal' retirement age of 65, and the numbers were staggering (meaning way higher than we could ever imagine to need). I began questioning why someone would keep working just to get super rich. I mean, what's the point? That question led me somehow to Mr. Money Mustache and then it all made sense.

    I do have a second chart that I'll be writing about soon that kind of prevents me from over or under-estimating. Basically this chart takes our account balances by month up to current, then shows future months at the 7% return having started from the beginning of our investing.

    So if the market has been great, my chart reflects a market correction back to the 7% long term return. If the market tanks, the chart reflects a bull market to catch back up to the 7% LTR.

    I also have one more chart that takes market returns since the S&P came into existence and randomizes returns at the click of a button. In a majority of randomizations, our long term 7% number comes out on the low end. Haha, I'll write about this soon I think ;)

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    1. Big Guy Money,

      I know exactly what you mean by trying to project out until age 65, the amount of money that compounds that many years out seems a little excessive to me, also by the time I'm 65 inflation will have kicked that number up a bit anyways. But then again, I'm not saving only 10% of my income and spending the other 90% like a lot of people seem to do. For me I think that if I stopped saving completely and just fast forwarded to age 65 my investments would probably compound to a point where I would be okay in retirement. So all I'm doing now is just saving to close the gap by about 20 years or so. :)

      I'll be interested in hearing about your spreadsheets whenever you get around to writing about it, they sound much more complex than my projected numbers.

      Do you know what your motivations behind why you choose to use a lower pay increase per year in your spreadsheet?

      -Zee

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    2. Right, and having 20 years of our life back appealed to my wife much more than watching our spending only to amass a fortune. I also think you're a bit ahead of where we are. Heck, 3 years ago we had a negative net worth.

      If anything, I estimated on the low end because I'd rather assume 7% returns and essentially a cost of living increase than pull a Dave Ramsey, project 12% returns, and like you said wind up bummed that I have to work an extra 5 years. As long as I don't have to change jobs, my projection should be a near-worst case scenario (although the stock market could have negative returns for the next decade, which would throw a wrench in things).

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  2. I agree, a minor correction (or two) is better than a big market crash. I didn't have investments during the past big crashes, so don't know how I will feel about one. With all the doomsayers, I'm halfway expecting a big crash any time now, so hope that I will be halfway prepared for the shock of it!

    Looking at my long term financial goal (15 years), I think I've slightly underestimated rather than overestimated. This is my first year of tracking my savings and investments, I wasn't sure what kind of savings rate I could achieve or know how much I could save. I will be revising the long term goal, as I will have some data to work from.

    I think it's still important to continue evaluating the goals every year, to adjust where necessary - as you say, there are too many unpredictables, not only with the stock market but also with what life throws at you!

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    1. I'm hoping that "the great recession" was the biggest market crash that I will experience in my lifetime. I had investments at the time, but it wasn't the largest amount of money so I kind of lucked out. I also participated a lot on the upside so I think I probably benefited greatly from it. If the crash hit now it would be a very tough pill to swallow, I'm sure I would become more conservative of an investor but hopefully it wouldn't take all of the risk out of me.

      I know my dad takes the low risk low reward investment strategy now. He lost a lot in the dot com bust in the early 2000's and ever since then it's left a bad taste in his mouth for investing. So I guess you never know how you react until you've been hit by a bad crash.

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  3. Hi Zee,

    Thanks for the mention! For me, the long estimate is more of a guideline, but in reality I am not grounded to a certain age when I think I will retire. TBH - the plan is to have kids, and maybe just before or around when they goto college to retire - which is more like 46-50 years old. But, if I get there earlier maybe I will do some searching in different jobs to see what I truly like. The time will eventually come, just don't know exactly when, and it is more of a rough estimate.

    I guess I did a fairly simple calculation of 8% gains based off the last year's balance, I didn't assume any gains on the current contributions. I already have detailed and accurate schedules for paying off loans so those are pretty well known for me. Things can go better or worse, but I do also have annual goals and I am hoping to be a bit aggressive on those goals so that I can possibly make it there sooner. With so many variables over a long time frame nothing is for certain, but I know that over this time I am going to keep pushing for that goal month by month.

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    1. I think it's great to have a general idea of where you're headed but those big life changing events are hard to predict how they might affect you. I know children are not cheap so I'm not sure how you can really throw that into your guidelines, though if you did try to plan for that I'd be interested in what general guideline you threw in for that.

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  4. Great post, Zee!

    I started out with long-term goals only, but found that I wasn't as motivated to reach them since I'm an endless procrastinator. That's why I added some short-term goals into the mix and one continual goal (to save 50% of my income). Hopefully that's a nice balance between over- and underestimation!

    Since I've only started investing in stocks, I'm unsure what to expect from the market. Of course, I don't expect a 20% yearly increase like 2013. My main calculations on reaching FI are based on a 6% average compounding growth rate, viewed by many as being conservative.

    Time will tell, I guess!

    Have a great weekend,
    NMW

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    1. Hey NMW,

      Long term goals are really hard to imagine, I'm guessing that's why most young people don't really save that much for retirement. They figure the goal is so far away that what's the point. I actually do have a mental goal about spending each month too, I try to keep my spending under a certain amount. I'm not sure why I choose to keep spending down and not saving up, though in my case those two are exactly the same. I think it's because my spending was a smaller number so it was easier to track.

      But that's awesome that you're saving 50% of your income, keep that up for a few years and suddenly your investments will do more of the work than your contributions.

      -Zee

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