Monte Carlo Simulation”
May 12, 2009
Depending on the client’s goals and priorities, we may have recommended a portfolio with less risk (our indexed balanced income portfolio was down around 12% in 2008), allowing the client to spend $11,000 a year more and target an $800,000 estate. With this recommendation we would have also warned the client of the risk of becoming underfunded AND overfunded and the portfolio values that would trigger a change to the plan. Becoming underfunded isn’t a crisis if you are prepared for it and know what choices you would make to respond to it. The comfort zone chart and the table below shows the likelihood that the markets will misbehave, and the portfolio values that serve as an early warning system indicating that a change to the plan and new recommendation is needed.
A year later, following the events of 2008, our balanced income portfolio declined 12% and we would have offered new advice. Depending on the investor’s priorities of spending, estate value and the desire to avoid investment risk, any of the three choices below (all with 83% confidence after the 2008 decline) might be recommended.
Of course, the markets in 2009 might repeat the devastating markets of 2008. We always assume that uncertainty is present. But our use of Monte Carlo simulation in our patent pending Wealthcare advice process does not coerce people into needlessly sacrificing their lifestyles. If the market downturn of 2008 was repeated for the next three years, we would ultimately get to that acceptable scenario with $28,000 in spending, a $500,000 estate and a balanced portfolio with 60% equities. There is a chance of four straight years like 2008, but is it really wise to sacrifice 28% of your spending and take 28% more investment risk to “be successful” if 2008 is repeated for four straight years?
The industry encourages people to sacrifice their lifestyles and take their maximum tolerance for investment risk, regardless of whether it is necessary or wise. Just think of how much money they would all have to invest!
Using Monte Carlo simulation in the manner we do enables people to make the most of their lives with comfort and confidence. Isn’t this what the Wall Street Journal would suggest? Or, should investors live their lives planning on four straight 2008s?
Sincerely,
David B. Loeper, CIMA®, CIMC®
Chairman & CEO
Financeware, Inc.
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