How reasonable expectations improve your chances of achieving financial goals

Dev AshishMoneycontrol Contributor

Unreasonable expectations are the biggest problem for many investors. Most of them will not accept it, and in fact, most of them don't even know about it.

Nevertheless, it is true. And just why do people have unreasonable expectations when investing? It is generally because of their overconfidence or the lack of knowledge about financial history and risk-return trade-off.

Let's be fair here – it is natural for people to be influenced by the recent performance of their investments.

For example, someone who started investing in 2004, would have been extremely happy to see the next three years deliver 42.3 percent, 46.7 percent and 47.1 percent (annual returns of 2005, 2006 and 2007 on Sensex).

As markets rose, investor expectations continued to rise and people started believing that such "high" returns can be easily achieved in future and those who had such unreasonable expectations chased unrealistic returns by taking risky bets. Sadly, we all know how it ended - after three great years (2005-2007), markets in 2008-09 fell like a pack of cards.

Nobody wishes for volatility in returns, but we cannot deny or ignore it.

Equity will deliver decent inflation-beating average returns of 12 percent or even more in the long-term. But remember, it takes years for these returns to stabilise and become realisable in CAGR terms. There will be years where your returns would be negative, and there will be years where returns would go through the roof. But this doesn't imply that we build our expectations only on the basis of the high-return periods.

Does having unreasonable expectations create problems in personal finances too?

Yes, it does.

One well-accepted view of personal finance is that the real purpose of investing is to have enough money, at the right time, to achieve your real-life financial goals.

When planning your financial goals, you need to have some return expectations, based on which you will know how much to invest in order to achieve the goal. And the key here again is to keep realistic expectations.

Suppose you have a goal - your daughter's higher education - for which you need Rs 30 lakh in 12 years.

If you assume 20 percent average returns from your investments, then you only need to save about Rs 5,200-5,500 per month for 12 years.

But what if your investments don't perform as 'expected' and instead deliver just 12 percent average returns?

You will not meet your target and will end up with just Rs 17.1 lakh as returns.

This may lead to an education loan to bridge the gap in funding.

So what went wrong?

The answer is - having unrealistic expectations to begin with.

The average return of 20 percent is not impossible but is very difficult to achieve in long-term. It is good to be optimistic. But when it comes to personal finances, it is better to be realistic. Many believe that their investments should generate extraordinary returns. But that’s not what happens. Most people have and will end up with average returns.

Having an expectation of 12 percent return is more reasonable than that of 20 percent. Assuming the goal is still to save up Rs 30 lakh in 12 years, you will need to save Rs 9,200-9,500 per month for 12 years (at 12 percent average returns).

Keeping lower return expectations forces us to invest more. This is better than investing less and hoping and praying that markets do as we wish them too. Let’s not be at the mercy of markets doing extremely well to help us reach our financial goals.

When estimating returns from market-linked investments, we must acknowledge that there would be deviations from expected returns. The deviations on the upside lead to pleasant surprises. But it is the deviations on the downside that we should be prepared for.

And it is not just about investment return expectations. Using unrealistically low inflation percentage in calculations can make you believe that by investing very small amounts, you will achieve your goals perfectly. Unfortunately, if the actual inflation is higher than what was assumed, you will be short of the required funds for some of the very important goals of your life. And that is not what you want.

Remember, the biggest risk in investing is never about not beating the index or not having the best investment returns. Instead, it is the risk of not meeting your financial goals due to unreasonable expectations.

So, what should you do as an investor?

The basic advice here is to control what you can. And remember, you cannot control market returns. You can only control how much you save for your goals. It is always easy to achieve reasonable targets (like 12 percent expected returns) as compared to stretched ones (like 20 percent returns). If it means investing more, then so be it. At least you will know realistically how good are your chances to achieve your goals if returns are not very high. It helps build up a safety buffer in your planning.

At the end of the day, it is about reaching your financial goals. And that requires having reasonable expectations and taking sensible measures without getting too ambitious.

(Dev Ashish is a SEBI-registered Investment Advisor and founder of StableInvestor.com.)