By: Mary Brunson and Robert Bray  |   April 1, 2011
 

The farther down the road of life we travel, the more we seem to face life choices that while they  seemed clear at the time, find each of us perhaps looking back in bewilderment, muttering the rhetorical question: “What was I thinking?”

Imagine the power of being able to peer into your future to gain a good idea of what your life will be like in the future. One particular area of your life where such foresight would be very valuable is your finances. Knowing how much you will likely have saved, how much you will likely be able to live on, and how much you will likely leave behind for your kids, grandkids or favorite charity is considerably valuable information.

One way to peek into the prospects of your financial future is through a probability simulation commonly known as the Monte Carlo Method. This often-relied upon analysis is considerably superior to more commonly heard advice such as “just invest 5% of your paycheck and hope for the best.” The Monte Carlo Method simulates the potential effects of volatility, compounding wealth and inflation during an investment lifetime.

By drawing from actual historical data for a specific risk level, The Monte Carlo Method simulates thousands of portfolio outcomes to arrive at a distribution of success at achieving a desired outcome. Generally speaking, a level of satisfaction for a particular outcome is reached when 95% of the simulations either reach or surpass the intended goal. IFA employs random number generation from 83 or 50 year periods of historical data sets and assumptions particular to the investor. These assumptions include the investor’s timeline to retirement, contributions, and the risk and return characteristics of the specific IFA Index Portfolio used, as well as whether or not the Index Portfolio has been set to Glide Path (reducing a level of risk with each passing year).

The graph below illustrates the two phases of an investor’s life: accumulation (saving phase) and consumption (spending phase). Applying the same starting assumptions, the possible outcomes range from prosperity to defeat, all depending on the range of volatility associated with the investments.  

Click to see the full chart

The Monte Carlo simulation enables an investor to get a good handle on how much money they need to accumulate so they will have enough to meet their needs (and hopefully some wants) in retirement. If the results do not provide a high enough probability of success, investors have valuable foreknowledge to help them improve their odds for success. An investor can identify a shortfall that may trigger them to save more, increase their risk level (to the greatest extent their risk capacity allows), decrease their anticipated expenditures in retirement, or push back their retirement all together, giving the investor more time to accumulate and less time to consume.

Revisiting the Monte Carlo Simulation each year allows investors to make sure they are on course — much like an onboard navigation system for a car. The closer one gets to their destination, the more finely tuned the directions become.

Work out your financial future right now using the Monte Carlo Simulation. This sort of disciplined analysis will likely go a long way toward preventing the regret of looking back to your younger days wishing you knew what you know now. This process might permit your 75 year old self the opportunity to tap your current self on the shoulder and say, “Thought you’d like to know.”

It is IFA’s privilege to share this information with you. Each of our investment professionals welcomes the opportunity to assist you in your quest for risk-appropriate, low-cost returns. To learn more, please call 888-643-3133 or visit ifa.com.
 

Whats New at IFA
 

March 26, 2011 Two new incredible charts that display data on Simulated Passive Investor Experiences: Time Diversification of Index Portfolios and Histograms of Simulated Passive Investor Experiences.

March 24, 2011 Two new Blogs: Concerns with Hedge Funds and Currency Diversification

March 22, 2011 THE BIG QUESTION: What are the chances that you will run out of money in your retirement? Now IFA will estimate this probability using a Monte Carlo Analysis of the risk of ruin. Just enter your assumptions in this form. What is the Monte Carlo Method?

March 21, 2011 An Oldie but Goodie from 16 Years Ago. Rex Sinquefield explains why all the news is baked in the cake and active managers have no advantage over the combined wisdom of all the market participants.

March 10, 2011 Should you get out of the market? Looking over the long term, David Booth reviews the history of the stock market and highlights the importance of time, not timing, in the achieving long term investment success.
Kenneth French explains why Manager Picking is such a terrible idea.

The IFA Blog has several new posts. Risks Worth Taking by Jim Parke
Thoughts from IFA on Fools and Children by Jay Franklin
Morgan Stanley Smith Barney To Cut Up To 300 Advisors and Trainees, by Mark Hebner
The Number of Investing Suckers Is Endless by Dan Solin

March 9, 2011 The Efficient Market Hypothesis says that prices reflect all available information. In other words, the information is "Baked in the Cake". In a strict view, it says that it is impossible to beat the market. It also indicates that you are always paying a fair price. Fair prices are set so the investors are rewarded for the risk they take.

© Index Funds Advisors 2011