Whether planning a current budget, estimating retirement need or predicting returns on a portfolio, growth rates for cash flows – income and expenses – are central to the results. If the numbers you use are close to the reality, then perhaps your planning will be a worthwhile indicator. But maybe not.
We all know that the government puts out a variety of measures of inflation in attempts to both report and predict what is happening and going to happen with prices and the cost of living. If we have thought at all about it, we also know that some of these measures do not really appear to make sense for individuals trying to budget for any period of time. Since housing, transportation, food and clothing are important to just about all of us, a measure which excludes one or more of these items is not helpful to our understanding of what really goes on.
However, the numbers we use to predict how much prices are going to change (likely increase) or income may grow or investments may go up or down, are essential if planning is to have any value. It has not been that long since we graduated from using a straight-line growth factor which not only ignores the volatility in markets and prices but fails to account for how various items and activities differ in their rates of change.
So we know that one number does not fit all. And we can do some pretty good guessing – things like medical or college related expenses tend to grow pretty fast, the interest rates we can earn on our money typically are fairly low and we can borrow at fairly low rates. But at what point might we have too many numbers and too many assumptions and moving parts in our plan? That may lead to more errors or uncertainties that we realize.
Just as some of us tend to oversimplify to get to the bottom line, others overcomplicate the matter and get to the point of nitpicking where it will not help us in our planning. One fairly happy medium may be to assume our expenses are going to increase a little more than the commonly accepted rate while at the same time assuming that inflows are going to increase a bit below such a rate. Since we will be closely watching what really happens and adjusting our plan as we go, we can adjust for any significant deviations while knowing we are not mindlessly assuming the best.