However, now is the time to remember that using short-term portfolio returns is not an effective way to evaluate the success or failure of an investment plan and may lead clients to make choices that will affect their ability to meet their long-term goals.
A more preferable method for evaluating an investment plan is to estimate the likelihood that a client will be able to reach their retirement goals using Monte Carlo simulations. A Monte Carlo simulation evaluates uncertain outcomes by conducting many trials with a given set of assumptions. In our case, we can use the Monte Carlo simulation tool in the Investment Planning Center to determine a range of final portfolio values given assumptions that include the probability distribution of portfolio returns, the client’s time horizon, and the amount of contributions and distributions, etc. We can then evaluate the likelihood of reaching a client’s goals by counting the number of simulations that result in a positive final value divided by the number of simulations performed (the Investment Planning Center performs 1000 simulations each time “Re-Run Monte Carlo” is selected). The percentage that results is the proportion of simulations that end with a final cumulative value greater than zero.
Evaluating investment plans using Monte Carlo simulations results in a more realistic assessment by providing a range of possible outcomes rather than using a single outcome. In addition, Monte Carlo simulations allow us to maintain a long-term focus because the results are determined at the end of the investment horizon.
Understanding the percentage discussed above is a bit more nuanced than at first glance, however. Instead of discussing the investment plan in terms of success and failure, we should view the likelihood that a portfolio ended with a cumulative value of zero as the likelihood that a change in the investment plan will be needed at some point in the future. This is intuitive because a client would not keep spending at the rate set in the investment plan once it becomes clear that that rate is unsustainable. On the other hand, having a probability of maintaining the investment plan that is too high may indicate that the client is not spending enough money and that they could afford to have a better quality of life in retirement. On the other hand, having a probability of maintaining the investment plan that is too high may indicate that the client has the flexibility to increase the amount of the distributions in retirement. Typically, we like to see the percentage of maintaining the investment plan at 80%; this provides a reasonable tradeoff between a sufficiently high probability of success and a level of distributions that meets the client’s goals.
Instead of discussing short-term performance this quarter with your clients, run a Monte Carlo simulation in the Investment Planning Center and discuss the likelihood that your clients will need to make a change in their investment plan.
To help facilitate the discussion, you may use the Manage Smart Portal function on the My Plans page in the Investment Planning Center to provide access for your clients; this will help make them an active participant in the discussion.
For more in depth analysis, the Financial Goal Plan module in the Investment Planning Center can analyze more specific goals that the client might have beyond retirement. By framing the discussion in terms of the likelihood that the client needs to make a change to the investment plan, advisors can help keep the focus on achieving the client’s long-term goals and help clients avoid mistakes that could impact their ability to meet those goals.
IMPORTANT: The projections or other information generated by the Investment Planning Center regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
Results from Investment Planning Center simulations may vary with each use and over time.
All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.
1Morningstar Direct, October 2014. ), U.S. Value Stocks (Russell 1000 Value Index), U.S. Small Company Stocks (Russell 2000 Index), International Developed Value (MSCI World Ex USA Value Index (net div.)), International Small (MSCI World Ex USA Small (net div.)).