2015 February

We have three topics to discuss in this communication:

  • Excessive Optimism in Financial Plans
  • A Perspective on International Funds
  • What To Do When the Stock Market Swings

Excessive Optimism in Financial Plans

Here at Guideway, we have been busy finishing a paper we intend to have published about statistical errors in standard financial forecasting. The paper conveys some reasons why financial plans should be more conservative than common industry tools usually indicate. We would like to share some highlights of the findings.

A high percentage of financial planners rely upon software tools to create financial plans, especially for retirement. Many programs use a common method for risk assessment and forecasting called Monte Carlo. Monte Carlo works well with perfectly accurate input data. However, the historical data for financial returns is limited – there is only a certain amount available. When Monte Carlo is fed a limited amount of data, the forecast errors tend to be large. Imagine trying to forecast a baseball player’s season batting average by only using the average from his first game. The first game can produce an extreme batting average that would not be close to the season average. The same is true for financial forecasting. The potential for misleading results from a small set of historical returns, such as only 20 years, is very large. Extrapolating forecasts over longer periods, like in 30 or 40-year retirement plans, compounds the error.

To make matters worse, the errors are generally on the optimistic side, meaning investors are presented a rosier picture than reality. This is especially true of forecasts and risk assessments for younger investors, conservative investors, and for portfolios that include international or other newly created funds. As an example, for a 30-year old who can tolerate a 10% chance of a shortfall in yearly retirement income, Monte Carlo will project an income at age 90 that is five times higher than unbiased projections, on average. Furthermore, the actual risk of shortfall will be 27% instead of the reported 10%.

While adjustments to Monte Carlo may possibly lessen the bias, the modifications would be challenging and perhaps not precise. For this and other reasons, Guideway has implemented proprietary planning software that does not require Monte Carlo, and it eliminates the optimistic bias altogether. As far as we know, ours is the only software that accounts for limited data, and this feature significantly reduces the risk of shortfall for clients.

Forecasts and plans from Guideway may seem more conservative than others, but when it comes to retirement planning, accurate projections are very important. No one wants to find out later in retirement that they over spent because of an overly optimistic financial plan.

A Perspective on International Funds

International funds have become quite popular in recent years. Some advisors recommend that investors hold 30 percent or more of their investments in international funds. While reasons exist to include international funds, in order to prevent surprises, investors must understand the inherent uncertainty these funds introduce. In particular, the lack of extensive market data for international markets, as mentioned above, is a concern that frequently is not given enough consideration.

One of the main ideas in favor of international funds is that they tend to perform somewhat independently of US investments, so they add diversification to a portfolio. At times when US stocks have been down, international funds have been up, and vice versa. Holding assets that behave oppositely offers beneficial protection for the portfolio against market swings. Furthermore, international funds have tended to have higher returns than domestic funds over their short existence.

Unfortunately, the lack of historical data for international funds introduces an unpalatable amount of potential forecasting error. Even when systems adjust for limited historical data to minimize bias, as with Guideway’s software, a certain degree of forecast error always occurs with any estimation. The size of the error depends greatly upon the number of years of historical returns. The more data, the smaller the forecasting errors tend to be. Again, think of the baseball analogy. For this reason, we believe that in order to comprehend the level of uncertainty in a portfolio, sticking to boring domestic stock and bond funds is best.

In the late 1990s, we conducted a casual experiment using a newly formed sector fund with five years of history. This fund had been on an upward tear since its inception a few years prior, with returns averaging 20-something percent per year and little volatility. At that point, the best statistical forecast showed a 99% chance the fund would return over 15% per year after inflation. The implication was that with only a few thousand dollars, almost anyone could be fabulously wealthy and retire with very little uncertainty. This result was obviously incorrect.

The problem was not with the statistical analysis. It was perfectly correct. The catch was that, with any statistical analysis, the estimates are correct on average. If instead the projections were based upon many different funds with 5 years of history and different starting years, the projections would be correct overall, but not necessarily correct in any single example. With short histories, and therefore little data, projections and risk estimates tend to be disturbingly inaccurate from case to case. When a very large number of historical years of data is available, the projections and risk estimates would be very accurate.

The primary philosophy at Guideway is to utilize high quality, low cost domestic index funds with extensive historical records that improve forecast accuracy. Rather than trying to maximize returns, what matters is optimizing the probability of achieving a financial goal while also minimizing the risk of failure. With almost 90 years of recorded history, domestic index funds offer a much more predictable picture than international funds, which are typically less than 20 years old. Furthermore, almost 50% of the revenue of the S&P 500 arises from other countries since numerous American companies sell into international markets. Therefore, we believe that a portfolio does not necessarily need to include international funds. A successful retirement depends upon having a reliable, unbiased long-term plan, not one that is skewed and over-inflated. Staying with domestic stock and bond funds enables improved forecast accuracy.

What To Do When the Stock Market Swings

Recently the stock market has gotten a little bumpy, as the chart below shows. During times such as these, a flurry of news articles usually ensues, which often drives investor anxiety. Magnifying the concern further, reputed expert prognosticators weigh in regarding the immediate action investors should take, but frequently the opinions are contradictory.
Despite the uncomfortable ride, we recommend clients stay the course. Market volatility is not unusual, and it is to be expected. Guideway’s long-term forecasts account for the short-term volatility, and we optimize the portfolio to maximize the probability of achieving your goals (or equivalently, achieving the maximum goal with a desired probability of success). Investors who move in and out of the market according to their emotions introduce unnecessary risk and no longer maintain an optimal portfolio mix. This will increase the probability of falling short.
Keep in mind that investing for retirement is a long process over several decades. Even individuals who are already retired may have a two to four decade investment period remaining. It is important to establish and follow a retirement plan for the long term, not become overly stressed about short-term issues. By short-term, we mean a few years, not just last month! Losses will happen every few years and may even last for several years. But, achieving the end goal is what is important.

2014 Market Volatility

2014 Market Volatility

Of course, even with rigorous mathematical analysis and portfolio optimization, risk still exists. It cannot be eliminated. Investors should always be mindful that shortfalls can happen and have a plan should one occur. A good approach is to have a retirement budget that includes more than just the necessities. It should include travel, leisure activities, dining out, etc. Should a shortfall occur, the fun items can be reduced temporarily to take care of necessities.
To provide more insight into potential investment outcomes, we have updated our planning process to include potential one-year losses. The intent is to show ahead of time what type of volatility our clients may face with their portfolios. Think of it as a “worst case” view. The purpose is not to be pessimistic, but rather, for clients to gain confidence in advance of market uncertainty. Knowing what to expect helps all of us have the fortitude to stay the course when market drops occur (and they will). We will roll out the new information to clients in February, and we will continue to develop materials to help our clients prepare for volatility.

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