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Step 5 is where all of your work in Steps 1 - 4 are brought together and the validity of your financial goal’s estimates are tested.

To complete Step 5 you will need access to a calculator that can project the future value of your accumulated and invested savings for each year into the future. Using a projection calculator, you can input your starting date, the dollar value of your current savings allocated to your financial goal, the dollar value of your financial goal, and the amount that will be contributed regularly toward your financial goal. The calculator will then project the future value of your savings and the rate of return required to achieve your financial goal.

Note: InvestingForMe provides you with  a Projected Annual Portfolio Value Comparison calculator. Your calculations can be saved to your member’s My Folder section for future review and updating. This makes tracking your future success effortless and timely.

This calculated required average annual rate of return will help you to decide whether or not your financial goal is achievable and whether or not your estimations of your Time Horizon and the dollar value of your financial goal are achievable.

Example:  Let’s say that you’re 30 years old and you have accumulated $30,000 of savings. You plan to keep working for the next 35 years, your income and expense analysis shows that you can comfortably save and invest $4,000 each year and your financial goal is to have accumulated $500,000 in savings for your retirement. So by using a financial calculator (we have used InvestingForMe’s Projected Annual Portfolio value Comparison tool) you can calculate that the required average annual rate of return your savings must achieve is 4.79%. Now you know the average annual rate of return required for your savings in order to achieve your financial goal!

Note: This calculation is important because it helps you to define just how much risk and volatility you will need to accept from your investments and this rate of return is used to guide the design of your investment portfolio.

Member's Note: Calculating a rate of return is easy if you only invest in one type of asset. But what if you invest in two or three asset types - stocks, bonds, cash, etc? And the calculation can get even messier if you invest different amounts in each  asset type! To make this calculation easier, InvestingForMe has created a Rate of Return tool. Simple enter your asset allocation percentages and expected rates of return for each asset type. The tool can be found in the IFM Tools section. Oh, and yea, once you put in your numbers you can also save it to My Folder for future reference.

Example:  Let’s say that you have accumulated $30,000 in savings and your income and expense analysis shows that you can comfortably save $4,000 per year, and that your financial goal is to have accumulated $500,000 at your date of retirement by age 65. But your current age is not 30. Let’s say you are 35, 40, 45, or 50 years of age. What is the expected rate of return that your savings must achieve to reach your goal? We have calculated the rates for you below:

  • For a starting age of 35, your rate of return will need to be 6.11%.
  • For a starting age of 40, your rate of return will need to be 8.03%.
  • For a starting age of 45, your rate of return will need to be 11.03%.
  • For a starting age of 50, your rate of return will need to be 16.30%.

As you can see, each calculated average annual rate of return above will require a portfolio design with differing levels of risk and volatility. So, contrary to the accepted investment rule that states a younger person has a longer Time Horizon and, therefore, can design a portfolio with a higher level of risk, this belief is actually false.

In fact, the opposite is actually true! The younger you are, the less risk you need to take on. In our example above of the 30-year old, they can probably achieve their financial goal by investing all of their savings in Guaranteed Investment Certificates (GICs), thereby earning a risk-free rate of return. In contrast, the 50-year old above will need to assume a lot of risk if they hope to achieve the 16.30% average annual rate of return and their financial goal.

So, if your calculated average annual rate of return seems unachievable or would require you to assume an unacceptable level of risk in your investment portfolio, then you may have to consider the following:

  • You should revisit the estimates for your financial goal’s Time Horizon and future dollar value.
  • You may need to extend your financial goal’s Time Horizon, reduce the future dollar value of your financial goal, or increase the amount of saving contributions.
  • Revisiting your calculated savings contributions is often more difficult. To increase your ability to save and contribute more, you would need to be willing to make lifestyle changes and thereby decrease your expenses or increase your income by changing jobs, obtaining a second job, or working longer hours.

Remember: In the end, your required average annual rate of return must be achievable and realistic given your Starting Point, your goal’s dollar value, your goal’s Time Horizon, and your ability to save.

Proceed to Step 6: Define Your Investing Personality

 

Note: This article might be of interest to you: What rate of return will your investments earn in the future – 12%, 8%, 4%?

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