Overview – Sometimes, Investment Assumptions Are Necessary
Investors won’t always have all the information they need to perform certain calculations or to help finalize a decision.
Of course, investors should always try their best to get the information they need. Whether it’s using conventional means or thinking outside the box, there really isn’t any excuse for an investor not to try.
Unfortunately, there will be times when, even after exhausting all their options, they simply won’t find the information they’re looking for, or what they’re looking for just isn’t available yet.
In those instances, an investor can either choose to sit and wait until the information they want appears, or they can make some assumptions to help advance their work and make the necessary adjustments as new information starts to appear.
Nobody likes to make guesses, especially when it comes to something as important as investing. However, investors don’t have the luxury of getting all the information they want, when they want, all the time. So, occasionally making investment assumptions comes with the territory.
Before using investment assumptions in your work, there are some things to be aware of.
Your Investment Assumptions Should at Least Be Realistic
When making an assumption, whether it’s in investing or some other endeavour, it’s important to remember that they serve as placeholders for the information you currently don’t have.
Investment assumptions should be replaced with facts as quickly as possible, but that doesn’t necessarily mean your assumptions need to be wild guesses. If anything, a good investment assumption tries to replicate what the facts may potentially look like as much as possible.
To get the most out of your assumptions, they should be realistic. “Realistic” in this context means the assumed information should have some sort of factual basis or justification backing them, not just something that was pulled from thin air.
For example, imagine you’re looking at a company whose profit over the past 10 years has grown annually at a rate of 3%. In addition to this, you also learn that the industry average is a 5% annual growth rate.
You’re interested in investing in this company so you make some assumptions, one of them being its future annual growth rate for the next few years. What should that number be?
Based on the information you have, an annual profit growth rate between 3% to 5% sounds fairly realistic. You can even go slightly above or below this range if you wish to make optimistic or conservative projections. This may not be the case once the real numbers are eventually released, but for now, this is the best assumption you can make without making a wild guess.
Conversely, assuming the growth rate to be greater than 10% would be absurd since the historical and comparative data doesn’t justify this at all. Who knows, maybe the company will experience rapid growth very soon, but again, based on what you know so far this assumption is very optimistic and is probably unlikely.
One of the worst things you can do when making investment assumptions is to make them unrealistic, or worse, make them too good to be true. After all, the point of making assumptions is to put in temporary pieces of information you feel will be as close as possible to the real facts.
Your investment assumptions don’t need to be perfect: the point is that your assumptions should at least be somewhat close to what you expect the facts to be.
By doing this, your work based on your assumptions shouldn’t differ that much when you eventually replace them. Your assumptions may be off once the facts are made known, but at least they had some sort of reasoning behind them and weren’t completely random.
In addition to making sure your assumptions are as realistic as possible, it’s also important to update your assumptions the moment new information becomes available.
When Presented With New Information, Modify Your Investment Assumptions Accordingly
Assumptions are meant to be replaced as quickly as possible with real data. Sometimes, however, you may come across new information that may not be sufficient to replace an assumption entirely but provides new insights you previously weren’t cognizant of.
Whenever you’re presented with new information that pertains to your investment assumptions, you should adjust them accordingly and do so as quickly as possible.
Using our example from earlier, your initial assumption was that the company you’re analyzing will experience an annual profit growth somewhere between 3% to 5%. However, you soon learn that the industry average was re-calculated, and the average is now 8%.
With this in mind, it would be wise to change your assumed future growth rate to fall somewhere between 3% to 8%. You’re still working with assumed figures, but the good news is that they’re more accurate than they were before.
You may not get all the facts you need right away, but you’re still responsible for making sure your assumptions take all current information you do have into account. An assumption is useless if it’s based on old information – there’s no point in using an assumption if it’s already outdated because your work will be outdated as well.
When working with assumptions, it would be foolish not to update them regularly. It usually doesn’t take long for new information to appear, and given the different sources of investment information available to investors, there’s really no excuse not to update them.
So, it’s important to keep your assumptions realistic and up-to-date. But what happens when the facts are made available, and they don’t live up to your expectations because your assumptions were so good?
Don’t Fall in Love With Your Investment Assumptions
It’s only a matter of time before your investment assumptions are replaced with the facts. Every assumption you make is transient – they come and go as you progress as an investor.
Sometimes, the facts may be very different from our assumptions, and the reality may not be what we originally had in mind when we were forced to assume certain bits of information. An intelligent investor understands that a discrepancy between assumptions and facts is bound to happen, and simply accepts what the reality is.
Investors need to let go of their assumptions once the facts are made available, no matter what. Falling in love with your assumptions because they work so well with your projections will do you no good.
The whole point behind making investment assumptions in the first place is for you to get a rough idea of what to possibly expect once the facts are available. An investor defeats the purpose of using assumptions if they refuse to let go of them simply because the results look great.
This is why it’s important to make sure your investment assumptions are as realistic as possible. If they’re too good to be true, then you’ll have a very hard time accepting the facts, especially if the facts aren’t what you expected them to be.
Back to our previous example, it’s easy to be optimistic and tell ourselves that profit will grow by 10% every year, but refusing to let go of this assumption when annual profit growth turns out to be just 4% is a very foolish thing to do.
Assumptions are expendable – the moment they can be discarded, do so. Investors must learn to accept that their assumptions may ultimately be incorrect, and to mentally prepare themselves in case reality doesn’t match their expectations.
Beware the Dangers of Extrapolating
Imagine you’re told that, for the past 5 years, a company’s yearly dividends have increased as follows: $2, $2.25, $2.50, $2.75, $3.
If you were to try and assume what the yearly dividend would be 5 years from now, what would your answer be? It’s tempting to say $4 because of the observed pattern, but always exercise caution when you start to use extrapolations to make investment assumptions.
There is very little certainty in investing: just because you’ve seen a specific pattern before doesn’t mean it will continue to be observed in the future. It doesn’t help that we’re psychologically hardwired to pick up patterns very quickly.
Extrapolation is so dangerous because it’s very tempting to assume that past data/observations will repeat. After all, the pattern is there, so we subconsciously tell ourselves that the pattern should naturally repeat.
However, investing doesn’t always behave rationally. It doesn’t matter how long a pattern has been observed in investing. All it takes is one bad business decision, a major economic/global event, or some other major factor to destroy what seems to be an established pattern.
It’s very hard to make investment assumptions far into the future because so much can change. The investing world evolves every day, investor sentiment shifts all the time, and the unexpected always happens.
Earlier it was mentioned that your investment assumptions should be as realistic as possible, and that point still remains valid. However, at the end of the day, a realistic assumption is still just an educated guess.
We use the past to try and make assumptions about the future because that’s the best information we currently have. However, when making assumptions far into the future, it’s very difficult to say with certainty what to expect.
Looking at our example one last time, assuming an annual profit growth rate anywhere between 3% – 8% sounds plausible for the next few years. However, making this same assumption five years or later down the road becomes more challenging because the level of uncertainty increases significantly.
We use the past to help inform our investment assumptions, but just because a certain pattern or behaviour has consistently been observed before doesn’t mean it will continue to be observed in the future.
Making investment assumptions via extrapolation is a very risky thing to do, and should only be done for assumptions about the immediate future, at most.
Wrapping Up
The reality every investor must live with is that they won’t always have all the information they want. Sometimes, no matter what an investor does, they have no choice but to wait for the information they want to become available.
An investor can either choose to sit and do nothing as they wait, or they can make some investment assumptions to keep their work going and get a rough idea of what to expect once the information they want is available.
Before making an investment assumption, there are a few things to keep in mind: keep them realistic, update them as you go, and let go of them once the facts eventually become available.
Your assumptions don’t need to be perfect because they’re meant to be temporary. At the end of the day, the whole point behind using investment assumptions is to better anticipate what may potentially happen in the future.
