Does Monte Carlo-Based Financial Planning Really Work? Part 2

Last week we looked at Monte Carlo as part of our larger planning process. This week we’ll zero-in on probability analysis, known as Monte Carlo specifically to explain how it works and more importantly, why you should care. Whether you are technical or very non-technical, this Brief is for you.

Monte Carlo (MC) analysis gets its name from the gaming industry that designed it to understand and mitigate the risks gambling houses face of being wiped out on any given night or at any given location. The financial services industry adopted the methodology and uses it in as many ways as there are providers of the service. This Brief will explain how we use it through our patented Wealthcare system.

Quite simply, we use MC or probabilities analysis to stress test our clients’ plans for sufficient confidence of meeting or exceeding the goals they value. Before Monte Carlo, the standard method of projecting savings or investment balances into the future used simple straight-line or average returns. But this method fails to address a major risk; that is the timing of when those returns will occur.

When people plan, they are relatively certain about when they want to spend money for things like college, or retirement, or building a beach house. Problem is, as financial advisors, we can’t know what the markets will be doing to their investments at the times they need to spend those big chunks of money.

In fact, timing risk impact is more subtle than during the big spending occasions. Any investor who adds to or spends money from his or her portfolio is impacted by timing risk in meaningful lifestyle terms. If they use only historical returns to guide their investment decisions they face almost certain disappointment.

In fact, the returns reported by mutual fund companies and other managers are almost meaningless, for a couple of reasons. Aside from the obvious fact that past performance is a poor indicator of future results, there’s timing risk. Returns reported by investment managers are simple returns from one point in time to another; they are scrubbed of cash flows in and out that are typical of real-world investors in their funds.

Let’s take an actual market example of two investment choices. It’s the beginning of 2000 and you are retiring. You would like to draw $80,000 from your million dollar portfolio annually as long as you can to supplement Social Security. Because we’ve taken you back in time we can tell you what the actual returns will be for the next 12 years for your two options.

An investment in Apple will yield an average annual return of 29.3% while an investment in a dull index portfolio of 60% stocks and 40% bonds will earn 4.9% per year. Which will you choose?

If you were tempted to make your choice on return alone, you no doubt chose Apple. However I’ve got some bad news: In mid-July of 2007 you ran out of money.

On the other hand, if you opted for the dull index portfolio, of 60% stock and 40% bonds, you would have plodded comfortably along, beyond 2007, 2008, 2009, 2010, 2011, and 2012. As of March 31st of 2012, you would still have $197,308.

Data Source: Morningstar

Take a look at the left table above. The first surprise might be how badly Apple got hit in 2000. When you were making your selection, you may have remembered that 2000 was a tough year for tech stocks. But the stellar 12-year return of 29.36% per year may have persuaded you to set aside the volatility of 2000 for the great returns that followed.

Now look at the same numbers as if you owned the investment portfolio. Notice what a cost to your lifestyle that horrific decline in 2000 would have inflicted. You would have suffered a drop from $1,000,000 in 2000 to $266,430, in just one year!

While this example represents an extreme case, it powerfully demonstrates how significantly timing risk can alter real people’s lifestyles. Monte Carlo, used properly helps us better plan and advise our clients for these kinds of uncertainty in future markets. Here’s an inside look at how:

The figure below graphically represents 1,000 potential life outcomes for a couple living out a 32-year retirement spending $65,000 annually (adjusted for inflation without Social Security to keep it simple) using a $2 million portfolio (60% stocks, 40% US Treasuries, and cash). Each colored line represents a 10th percentile (there are 100 virtual lifetimes between each line). While the chances for any one of the outcomes to occur are equal, notice how wide the range of potential outcomes is on the right-hand side of the graph. The analysis suggests our couple could end their lives $3.1 million in debt or they could just as likely die with $12.1 million in wealth, with 998 possibilities in between!.

(C) Wealthcare Capital Management, Inc.

So how do we gain any confidence from all these lines and uncertainty? The graph clearly demonstrates how vulnerable one is if historical market returns are his only guide to financial confidence; he can only react to what has happened.

It is better to take a proactive approach. With this tool, we can measure the uncertainty our clients will experience as they demand from the markets the wealth required to accomplish or exceed their goals. Notice that most of the lines end above zero. In fact, 830 of the virtual lives lived experienced market returns sufficient to meet or exceed our couple’s requirements for $65,000 annual spending, adjusted for inflation. Remember, we used a $2 million portfolio (60%/40%) that would be drawn down to zero, according to their wishes. Based on the analysis, a zero life/plan end balance occurred at the 83rd percentile. In other words, our couple can be 83% confident of meeting or exceeding their goals.

But confidence is fleeting, you might say. What happens in the real world when a 2008-like market comes crashing in and the S&P drops 38%? Let’s say our couple began a relationship with us December 31, 2007. During 2008 our Balanced model (60%/40%) lost 19.7% so our couple’s portfolio would be down to $1,541,000 after taking their $65,000 withdrawal for income. Certainly, that drop might rattle anyone who has nothing more to bolster confidence than CNBC or the hollow promise ‘it will come back in time.’

During our hypothetical initial December meeting, we informed our clients that there was a 17.3% chance of their portfolio becoming under-funded in its first year due to market volatility. In wealth terms that translated to $1,436,072. As their portfolio stood at $1,541,000 by the end of 2008, the couple’s confidence remained above our comfort threshold of 75%, so no portfolio or lifestyle or spending changes were required.

(C) Wealthcare Capital Management, Inc.

The plan report that we presented our clients would have included a lifetime snapshot of where their investment portfolio needed to be in today’s dollars for each of their remaining years in order to provide sufficient confidence of meeting or exceeding their income goals.

A picture of confidence is worth a thousand virtual lives !

(C) Wealthcare Capital Management, Inc.

Look again at the table entitled “Chance of Falling Outside the Comfort Zone.” It indicates that just in the first year, there is a 41.6% chance our couple will be outside what we consider an acceptable range of confidence. Because of this broad range of potential outcomes in a relatively short period of time we continually stress test our clients’ plans against new information to identify opportunities or risks when their plans become over- or under-funded, respectively.

Without a tool like this, determining life-plan confidence is nothing more than guesswork and guesswork is not effective life planning. We believe Monte Carlo, specifically as it is incorporated in our Wealthcare process to be the very best life plan stress-testing tool available.