Gaining confidence in an uncertain world
Life is uncertain, and that uncertainty especially applies to personal finances. Are you compromising your goals with your investment choices? Are you overreaching or not reaching far enough? There is always an element of uncertainty that may impact your financial success.Take investing for retirement. When calculating how much you might need to save monthly in order to achieve a certain retirement lifestyle, you might assume a certain dollar size for your nest egg, an average annual return on your investments and the number of years you have to save. For example, you might assume a $500,000 nest egg and an 8 percent return for 20 years. From that, its simple to calculate how much you should save each month to build your nest egg.The problem is, the odds are it wont happen. Its an illusion of stability. Thats because nothing happens every year exactly as planned. Investment returns, for example, might average 8 percent over those 20 years. However, during that time returns will vary one year to the next: perhaps 20 percent one year, 6 percent another, a 7 percent loss another. Similarly, the temperature for a given day probably wont be exactly the average temperature for that day. Unlike the daily weather, however, the sequence in which investment returns occur can make a huge difference in how large your nest egg really turns out to be. If returns are higher than average early on in the accumulation phase, the nest egg will probably be larger than you projected; lower-than-average returns early on means it will likely be smaller than you planned.The same approach applies to withdrawal rates from your nest egg. How much you can safely withdraw each year and not run out of money before your death will depend on, among other factors, investment returns, the inflation rate and whether you live longer or shorter than your life expectancy.The science of statistical modeling can help to provide a better feel for what your chances really are for achieving a particular financial goal. Statistical models have been used for years to help scientist make decisions in the face of uncertainty, and now they are available to simulate financial markets. These models can simulate thousands of different outcomes over a lifetime of investing. Some of these scenarios will assume strong market returns, consistent with some of the best periods in history for investors. Some scenarios will conform to the worst periods in investing history. The end result is a statistical assessment of how likely you are to achieve your financial goal given the uncertain nature of financial markets.Say you want to know how much you can realistically withdraw from your retirement portfolio each year and not run out of money. Your desired spending, assumptions about inflation, financial market returns and the relationships between these variables all are incorporated into the statistical model. The program then generates hundreds, even thousands, of variations of these numbers, each generation slightly altering a particular variable such as the sequence of investment returns or the average rate of return or a different life expectancy while keeping the target withdrawal rate the same.The result shows you the probability, given the assumptions used, that a particular spending rate will achieve the results you want. For example, you may find that you have a 75 percent chance of running out of money by withdrawing your ideal retirement-spending amount each year. This would be similar to the weather reporter saying the likelihood of rain today is 75 percent, which might encourage you to take an umbrella. Alternatively, the likelihood of your success may increase to 90 percent if you consistently withdraw a slightly lesser amount each year. The decision to take this particular level of financial risk, of course, is ultimately yours. Statistical modeling is not foolproof. The assumptions used need to be realistic. What happens if you experience a major financial crisis, such as an illness or loss of a job? What if you are unable to maintain the savings or spending patterns indicated? The impact could change your financial picture dramatically. By identifying a range of goals and assigning priorities to each goal, statistical modeling can prove to be a useful tool that provides a more accurate picture of a financial strategy. But it doesnt guarantee results. Through periodic monitoring, you can assess the impact that your actual savings and spending patterns, investment returns and portfolio values have on your probability of success and make changes to keep your plan on track to achieving your own personal definition of financial success. Nothing substitutes for common sense and a realistic overall plan that prepares for the uncertainties along the way.Fraser M. Horn and Dudley M. Irwin are investment advisers operating 1st & Main Investment Advisors in Edwards. Call 926-2500.Vail, Colorado
Support Local Journalism
If you don't follow the rules, your comment may be deleted.
User Legend: Moderator Trusted User