Wednesday, September 15, 2010

Personal Financial Life Planning RISK (Part B – Monte Carlo Analysis) – Part III Setting A Personal Financial Life Goal

If the Platte River an average depth of 3’ deep, most people over 3’ tall should be able to walk across without drowning. However, at some points, the Platte River is but 2” and other points 20’, so even Wilt Chamberlain would drown at the 2’ depth.
Thus, the average rate of return - The FLAW of AVERAGES – applied to personal financial life objective(s) is very ‘risky’ business – ironically increasing the risk that you won’t make your personal financial life objective(s).

Yet, average rate of return is still the employed by many financial planners, and cpas. Worse is that average rate of return is the predominant measure employed by actuaries determining the adequacy or inadequacy of public employees’ pension funds understated by multiple billions. (What does this mean to you? Higher taxes but that’s another story with the actuaries and politicians foolishly trying to obfuscate or defend average rate of return with accepted state of the art horse pucky. As one former Colorado Union official stated to me to paraphrase, “PERA (the Public Employee Retirement Association) funding is the nuclear bomb on the State of Colorado Finances.” And that statement was just on the underfunding using an ‘average rate of return.’

It is the sequence of the rate of returns that matter – not the average rate of return!

An example per Dr. Sam Savage’s Flaw of Averages.

“ Suppose you want your $200,000 retirement fund invested in the Standard & Poor's 500 index to last 20 years. How much can you withdraw per year? The return of the S&P has varied over the years but has averaged about 14 percent per year since its inception in 1952. You use an annuity workbook in your spreadsheet that requires an initial amount ($200,000) and a growth rate for the fund. "I need a number," you say to yourself, so you plug in 14 percent. Now you can play with the annual withdrawal amount until your money lasts exactly 20 years. If you do this you will be pleased to find that you can withdraw $32,000 per year.”

At the end of 20 years using the 14% average rate of return, your capital would be exhausted and the investment finished.
Here’s the rub – REALITY IS NOT AVERAGE RATES OF RETURN. Rates of return are volatile – they fluctuate – they are not smooth like Original Skippy Peanut Butter – but are chunky and can wipe out your duration in a JIF.
Given real market rates of return starting in the following years, here is how long the $200,000 would last:.

1973 – out of money in 8 years
1974 - capital intact despite 20 years of payouts at the end of 20 years
1975 - out of money after 13 years
1976 - capital exhausted in 10 years

How come?
The Dow Jones was 1020 at the beginning of 1973 but by the end of 1974 it was 616 or a 40% decline whereas by the end of 1975 having invested in 1974 the Dow Jones when the Dow was 616 was up 38% to 852!

In rate of return and the probability of making the goal, its SEQUENCE, SEQUENCE, SEQUENCE!

It’s the sequence of rate of returns NOT average rate of return!

Beware of averages alone – except in Lake Woebegone – or your personal financial life goal will woe be gone.

Therefore, employing average rates of return, alone, is RISKY and deluding. (Again, Risk is defined as the whether you make the goal or not per PART A. At a gut level: RISK is the danger of not making the goal – the failure to achieve the goal causing negative consequences.)

Okay, what then is an additional standard metric to employ besides ‘average rate of return’ and it’s flaws?

Monte Carlo Modeling.

Simply stated, Monte Carlo Analysis (which goes back to the Manhattan Project) models multiple (often many thousands) alternatives to come up with the probability (as stated as a percentage) of making one’s goal.
Thus: given w amount of resources, deployed in x allocation (% of stocks, bonds, cash etc) for y period of time, at Z payment per year, a existing asset level of assets, beginning in b etc – what is the probability of making the goal?
It should be noted that Monte Carlo Analysis did not save clients and their planners from the financial meltdown ‘black swan’ recently where 15 of 16 asset classes declined. Monte Carlo gives probability not certainty. It also should be noted that Monte Carlo, which typically requires a larger if not much larger funding level to achieve the goal, is an AUM financial planner’s dream of increased fees.

If all you know is a hammer, everything will look like a nail
Dr. Abraham Maslow

What is an AUM financial planner?
The compensation for this financial planner is based to assets under management. Thus, the “more” assets under management the “more”, he or she gets paid.
There is an inherent conflict between this type of compensation and it conflicts with the concept of Enough which is based achieving the financial goal with the less risk possible. The conflict occurs where the goal can be still be reached at a lower rate of return with the trade off being less risk (risk of not making the goal!). Thus, AUM planners inherently are MOREons though their pat answer would be ‘if we aren’t making the goal, we’d be fired – which serves as a check and balance.’ However, offsetting this response is AUM tends to make the goal relative to an external comparison – ‘how did I do versus the Dow Jones, the S&P, etc.’ rather than the internal goal!
There are good reasons and real reasons. Increased compensation – consciously or unconsciously – is the real reason – for the AUM compensation model (the hammer) with too many clients getting ‘nailed.’

(On a continuum of commission/transaction financial planners and flat fee, bracketed or hourly financial planners, I consider the AUM planner’s compensation a faux fee only planning or fee only planning not lite.)

In any event, Monte Carlo most likely will require additional assets under management therefore I prefer the assistance of a fee only planner who charges a flat fee, an hourly, or a bracketed fee (no less than, no more than based to an hourly but capped).
In summation, relative to making the goal, not running a Monte Carlo analysis, regardless of it’s windfall to AUM financial planners, would be close to malpractice – which is exactly what state governments like Colorado are doing which will wind up costing taxpayers and harming your personal financial funding. How? They plans which are underfunded on the ‘flaw of averages’ are way way way understated – in worse shape given monte carlo analysis. To get to the 90% or 95% funding level would require some or all of the following (assuming an actuarial emergency gets the states out of their locked in obligations):
· Increase in taxes or lowering of services
· Increase in bonds from the state – lowering credit rating, paying higher interest from general funds thus lowering services unless there is an increase in taxes
· Additional state and or employee contributions – again increasing or lowering services

Remembering it is not what you make but what you keep, if state taxes go up, your net rate of return goes down. You will then either have to increase your contribution to the goal and or increase the risk (really volatility of rate of return and remember ‘sequence, sequence, sequence’) to get a higher rate of return or lower the amount of the goal and or its start and duration.

Here is the effect of a .5% net increase in state tax rate on the growth of $100,000 for 20 years (7% net versus 8% net – inflation is not taken into account for this example) in reducing your assets:
8% grows to $466, 100
7.5% grows to $424,800

Thank the politicians (who are members of the state pension plans) for costing your goal $42,000…EVEN USING AVERAGE RATE OF RETURN!

State underfunding of employee/politician pensions, the personal financial ebola of higher education costs paying for Scholar Barons on tenure, and long term health care costs converge to cannibalize assets that otherwise would go to funding your goals and requiring less volatility, resulting in the delay or reduction of the goal or worse taking on more volatile ‘risky’ assets even illiquid assets – to meet the goal.

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