Back in the 1970s, an OPEC oil embargo sparked a period of hyperinflation in America. To clamp down on rising prices, Fed Chairman Paul Volcker raised interest rates. By 1981, you were lucky if you could find a home mortgage for less than 16%. Business loans were going for 25%.
On the bright side, if you had money to invest, you could get a 5-year CD at your local bank for 12% interest!
Never slow to a party, the financial industry designed products that would flourish in a high-interest rate environment.
I remember being at one such presentation. I was a young man in a room full of older faces.
“By a show of hands,” the speaker said dramatically, “does anyone in this room seriously believe we will EVER see interest rates below 10% again in our lifetimes?”
No hands went up. The audience laughed, so I did too, unsure why this fact seemed so certain to everyone else.
Of course, that period of hyperinflation didn’t last. That’s because economic conditions are in constant flux.
Case in point…
Like you, in recent weeks I’ve been paying $4 per gallon of gas—and grumbling. But do you remember just two years ago when crude oil was trading at -$37 a barrel! Thanks to COVID-19, no one was traveling, and nothing was open. For a brief time, owners of crude oil had to pay someone to take it off their hands!
My point is…things changed.
They always do. Interest rates change. Inflation rates change. Tax rates change. The circumstances of your life change. Your health changes.
There’s a word for the mental trap we fall into when we see things going in a direction and assume they will continue in that direction forever. That word is “extrapolation.”
Depending on its direction, extrapolation can lead either to overconfidence or extreme pessimism. In today’s market conditions, we’re seeing a good bit of the latter.
“My account is down 15% this quarter. If this continues, I’ll NEVER be able to retire!”
This is the flaw in extrapolating. It forgets that financial trends come and go.
Concerning the markets, a review of history shows that markets typically trend in a direction…until they don’t. The overly optimistic investor fails to see the inevitability of occasional market corrections. The overly pessimistic investor panics on every down day.
Better to save and invest regularly and let market volatility work in your favor. How? By consistently putting a percentage of your earnings into your company’s 401(k) plan, you can benefit from market prices going both up and down. When prices are up, the steady dollar amount you invest buys fewer of the more expensive shares. When prices are down, your monthly investment buys more of the less expensive shares.
To recap: The long-term direction of the modern age is progress and the creation of wealth. But that upward trend is anything but stable in the short-term. The pendulum swings both ways. And it does so unpredictably.
That’s why planning is so critical. Balance and risk mitigation are key components of any plan that participates in the financial markets.
While participation in the financial markets can bring great rewards, it can also exact a dear price on the poor soul that thinks that what goes up will never come down (not even temporarily).
I’ve created a comprehensive checklist of pre-retirement questions for people who are 60-something. It’s free if you’d like a copy. Email me at email@example.com, and I’ll send it to you right away.
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This article originally appeared on Shreveport Times: The problem with financial 'extrapolation'