Posted by Tim Stobbs on April 8, 2009
I have a theory I wanted to share with you all. When doing retirement calculations people pick all sorts of margins of safety. They add an extra 10% to their spending, or reduce their investment return by 1% , or choose a higher inflation number, or in some cases they do all of the above. I’ve always wondered why people pick different margins of safety. Some pick very lean margins and others very fat margins. I think I know why.
I theorize that people pick margins of safety that are directly proportional to how willing they are to accept their back up plans or the concept of failure. So those without any back up plans and who have not even thought about ‘what’s the worst that could happen’ end up picking higher margins of safety than those who have back up plans and accept them as valid options.
Now obviously there are other issues around choosing the margins. If you are more conservative investor you will obviously choose a lower rate of return to do your calculations or if you have previously been through a period of higher inflation you are likely to pick a higher number. Your previously experience in life will also influence your choices.
Yet in the end, I believe the margin of safety is really a measure of your fear of the situation. So by planning out some back up plans and asking your can you live with them you remove that fear and hence chose a smaller margin of safety.
Well that’s my theory. What do you think? Is it crap, am I on to something, did I miss something? Please share your thoughts with a comment.