- Stephen Way
Updated: Jun 1, 2022
In my last blog post, I talked about the importance of having a financial plan that gets you from point A to point B. And, at a minimum point B includes your fundamental goals of a desired retirement age and standard of living. A sound plan provides you a high degree of confidence (or, high probability of success) in execution. Developing this confidence is the basis of this post.
First, how do you get from point A to point B in your plan? Generally, you save and invest during your working years to create a portfolio that will fund your living expenses and goals in retirement. A plan assumes a certain level of savings and, just as importantly, a constant investment return that grows those savings. Simple enough, but is a constant rate of return realistic? Not at all, obviously, if you follow the stock market just a little bit.
While returns have historically increased over long time periods, in reality they are not predictable from year-to-year (you can read more about this here). For example, let’s look at the one-year returns for the S&P 500 for three randomly chosen five-year periods:
Years Sequence of Returns (rounded to nearest percentage point)
· 1970 – 1974 +4%, +14%, +19%, -15%, -27%
· 1990 – 1994 -3%, +31%, +8%, +10%, +1%
· 2005 – 2009 +5%, +16%, +6%, -37%, +27%
Source: Dimensional Fund Advisors “Matrix Book 2018”
Not exactly constant returns! Stock market returns are essentially random in any one-year period. The risk posed by this random up-and-down pattern of returns is referred to as sequence of returns risk and can impact your financial plan in various ways (both negatively and positively). Ongoing withdrawals and bad early returns in retirement could result in a depleted portfolio before the end of your life. As advisors, one of our priorities is to focus on understanding the potential likelihood of negative planning outcomes associated with this sequence of returns risk.
How do we do that? When we develop a financial plan, one tool we use is called Monte Carlo simulation which simulates thousands of random sequences of investment returns over the term of the plan. The result of running these simulations is a set of potential projected planning outcomes. From that distribution of outcomes, we can develop an estimated confidence level of a financial plan being successful (i.e., not running out of money). For example, if 10% of the simulations resulted in your plan running out of money, you have a 90% probability of success – high enough to implement the plan.
What if our client’s plan has a low probability of success? In this case, we collaborate to restructure the plan until we achieve a satisfactory probability of success. Options include prioritizing and modifying financial goals, increasing savings and changing the strategic investment allocation. The plan is not a good plan until we have high degree of confidence in it.
Now, it’s important to keep in mind that, as with all financial modeling techniques, Monte Carlo modeling has plenty of limitations. However, if you are aware of those limitations and can interpret the results within the context of those limitations and the overall financial planning model, Monte Carlo modeling can be an indispensable tool in evaluating the strength of your plan.
So, I’ll pose this question to you: what is the probability of success of your financial plan? If you don’t know, let’s begin the conversation.
Setarcos Wealth Advisors LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
- Stephen Way
Updated: Jun 1, 2022
I was recently having dinner with a friend when she asked me a basic question about her and her husband’s financial situation. They have been saving diligently for years and she wanted to know if it was okay to put off saving for a few years in order to spend on a few large discretionary items.
The question seemed straight-forward enough. If they want to safely retire at a (relatively) young age, they’d had better save as much as possible and be careful not to dip into their savings too much. On the other hand, I thought, if they’ve been putting money away for many years, perhaps they’ve already saved enough for retirement. Wouldn’t that be nice!
Of course, without knowing anything about their financial situation I wasn’t able to answer the question. But I could lead them in the right direction with another question.
So, I asked her a simple follow-up: do you have a financial plan? Well, she said, “we have an advisor who helps us invest, but we don’t have a financial plan.”
Now, I’m not sure why one would pay an advisor who hasn’t helped you develop a financial plan. But, that’s a topic for a different day.
The point I want to make is that even a foundational financial plan would have helped answer my friend’s question. Put simply: even a basic financial plan is better than no plan at all!
A financial plan fundamentally gets you from Point A to Point B (and at a minimum, Point B is a desired retirement age with a comfortable standard of living). Planning is analogous to navigating, which is why it’s so critical. However, often couples and families are directionless because they fail to define and communicate their goals in the first place – determining what Point B looks like!
As advisors, our job is to engage our clients to start planning – what I like to think of as a process of clarity – and to help them successfully reach their goals. While our financial expertise is important, our value is often also behavioral in nature: to help clients take action.
So, the best answer I could give my friend was to take the first step. Engage an independent advisor to develop a plan. The benefits of having clarity and confidence in your financial decisions should far outweigh the costs.
Setarcos Wealth Advisors LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
- Richard Faw
Updated: Jun 1, 2022
"If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes."
- Warren Buffett
In the investing world, there are a million and one ways to define risk. Ok, not really. But there are a lot. Get a group of investors in a room, ask them each to define risk and you’ll likely get a handful of different responses. The most common definition is volatility. Stocks, for example, are considered risky because they are volatile. But if you’re a long-term investor, does volatility really matter that much? Aren’t there more relevant ways to think about risk?
Yes, yes there are.
If you’re a long-term investor, another (and, we would argue, better) way to define risk is the probability of having a permanent loss of capital. This happens when, for example, you sell something for less than you bought it. If you buy something and it temporarily declines while you still hold it, you have volatility but you have not had a permanent loss of capital.
Think about this in the context of a portfolio of stocks.
Let’s say you have a ten-year investment horizon and hold a diversified basket of stocks through an S&P 500 index fund. If you have absolutely no need or plan to sell anything from this portfolio over the next ten years, then, using the definition of risk laid out above (i.e., that risk is defined as a permanent loss of capital), this portfolio has low risk. Why? Because, over a ten year period, the probability of having a permanent loss of capital is low. Going back to 1950, there has been only one ten-year period (looking at calendar year returns) in which you would have lost money by selling after 10 years (2000 – 2009, towards the high of the dot-com bubble and low of the 2008-2009 financial crisis). In other words, historically speaking, there was about a 1.4% probability of losing money over a ten-year period. Now, there are a bunch of caveats to this, including that the future could easily be different than the past, that I’ve ignored intra-year holding periods and that inflation will take away part of your return. Still, you can see the odds are strongly in your favor if you have a ten-year holding period. What about other holding periods? Check out the chart below.
As you can see, once you extend out to about 10-15 years, the historical likelihood of having a permanent loss of capital has been quite low.
So, if you’re a long-term investor, don’t fret about the daily, weekly and annual ups and downs of the market. Ignore the silly talking heads who tell you where the market is going this year (hint: they have no clue). None of this matters to you. What matters is where markets are ten to fifteen years from now. And based on history, although there are certainly no guarantees, the odds are highly in your favor.
John Bogle, the founder of Vanguard, was definitely on to something when he said, "The stock market is a giant distraction to the business of investing."
Setarcos Wealth Advisors LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.