Two Analogies
Dr. Finke employs two interesting analogies to highlight some of the limitations of Monte Carlo modeling and to help individuals/clients better understand investment risk. With respect to his “Google Maps” analogy, he indicates,
“This analogy is important because many advisors view the original estimate of probability as overly static. When market conditions shift, they assume that if their client ‘stays the course’ and patiently maintains their portfolio allocation and spending strategy they will be fine in the long run. After all, when developing the investment policy there was a 94% chance of success.”He explains that this line of thinking is “wrong.”
The concerns about Monte Carlo modeling expressed in Dr. Finke’s article echo the concerns expressed by Michael Kitces in his post of December 7, 2015, “Is Financial Planning Software Incapable of Formulating an Actual Financial Plan,” when he said,
“virtually no financial plan today actually constitutes a real “plan” for anything. After all, the whole point of planning is to formulate the strategy of how to handle a range of possible future scenarios. If A happens, then we’ll do B. If C happens, we’ll do D instead.
Yet financial plans today, and the financial planning software that supports the process, is incapable of illustrating such scenarios and the appropriate responses! Answering a simple planning question like “how much do the markets have to decline before I need to cut spending in retirement, and how much would I need to adjust my spending to get back on track” cannot be easily answered with any financial planning software available today!”
Support for a Floor Portfolio
Dr. Finke concludes,
“A variable withdrawal strategy in response to investment risk requires estimating what percentage of a client’s spending is fixed. Fixed spending is the lower bound of the guardrail. Social Security, pensions, bond ladders, or an income annuity (SPIA or DIA) are the only assets that should be used to fund retirement expenses that cannot be reduced if markets fall.” [See our Glossary for definitions of annuity, bond ladders, SPIA, and DIA]We agree completely and encourage our readers to consider managing their risks in retirement by employing our Recommended Financial Planning Process to help them develop their spending budget and Floor and Upside Portfolios.
Take Away
Many financial advisors, and surprisingly, even some actuaries, believe that Monte Carlo models are inherently superior to the Actuarial Approach advocated in this website for the purpose of developing a financial plan in retirement. They believe because these models employ Stochastic rather than Deterministic assumptions, they are more “intricate” are therefore somehow more accurate. We disagree. We believe the issue of whether a model uses Stochastic assumptions or Deterministic assumptions about the future is a red herring. As noted in Dr. Finke’s “deck of cards” analogy, we all must live with the year by year investment result cards dealt to us by the dealer, and neither type of model can accurately predict our future. In our opinion, the success of an individual’s or couple’s retirement plan is much more likely to be dependent on:
- adequate consideration of goals,
- implementation of effective risk management strategies (such as establishment of a floor portfolio),
- plan flexibility
- reasonableness of assumptions used for future experience, and
- the adjustment processes anticipated.
