Testing Your Financial Plan

investment allocation, financial stress testFrom The Charleston Mercury, October 18:

Investment returns through September 30th have been quite good. Equity indices are up 13-16%, fixed income indices up 4-6% and liquid alternative funds are generally between the two. So, depending on your asset allocation, your portfolios may be up 6-12% or more year-to-date. Good stuff. 

The question, though, is when you’re doing your financial planning should you assume returns for the first nine months of 2012 will continue indefinitely or use some other numbers? Furthermore, when you do your financial planning how do you factor in unknowns that could derail your financial future? How do you develop and stress test your financial plan so you can sleep at night?

Let’s start with investment returns, the real “engine” of your financial plan. Asset allocation, of course, is the primary factor that determines performance. Despite the stock market’s recent results, the world and the investment landscape seem very uncertain these days. Is your asset allocation designed to protect and grow the assets you need for your successful financial plan? You’ll need to develop an estimated return for your allocation. Historical returns cannot predict the future but give you some direction. Should historical returns go back to 1926? The last decade? Last five years? These days it’s impossible to find a perfectly representative period given the worldwide changes in the last decade and the changes that are occurring every day. Even so, you’ll need to develop a realistic value as a starting point.

Calculate your planning by using your key variables, including assets, investment returns, expenses, inflation and eventual age and develop not just one result but a series of results for your plan. It will show how variations in rates of return each year can affect your results. 

This method is called a Monte Carlo simulation and it calculates the results of your plan by running it many times, each time using a different sequence of returns. Some sequences produce better results, some worse.  Ultimately, the simulation will produce a range of possible results with probabilities of success for a given set of variables.

Next, you will want to stress test these results by considering what happens if bad things occur. Some of the key “what ifs” are:

  • Inflation will be higher
  • You outlive your assets
  • Social security benefits are cut
  • Investment returns are less than expected
  • You incur uninsured health care costs

The Monte Carlo simulation is highly valuable in that it will be able to show you the probability of success of your financial plan if one or any combination of these stress test events occurs.

Stress test your financial plan. You’ll sleep better at night.

Lester Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt. Pleasant and Chicago. Les may be contacted at (843)577-2463 or les@dwmgmt.com