When I started this blog back in May 2007, the intent was to write about the day-to-day issues I faced as an independent advisor. Now, after 140 postings, we’re going to try something a little different. Though I will still write about my weekly adventures, the topics will coincide with the focus of the magazine and will change on a monthly basis. This month’s topic will be investing. The topics are as follows: Portfolio Construction Overview; Bonds; Stocks; and Alternative Investments. Let’s get started.
Portfolio Construction (Overview)
First, let me say that there are a number of good ways to manage money and I do not claim to have cornered the market on this. What I can say with a high degree of certainty is that I have discovered a method which has worked well and will share it with you this month.
Actually, it was during the bear market at the beginning of this century (2000-2003) when I stumbled upon it. Here’s where it begins. Perhaps the most important question I can answer is this, “What’s the required rate of return my clients need to earn to make their goals a reality?” Then, “How much risk will we need to assume to get there?” I only know of one way to arrive at the required return and that’s through financial planning.
After creating the plan, and assuming it is successful, I will “stress test” it by reducing the return until the probability of running out of money materializes. At this point, I know approximately where the threshold is, that is to say, the minimum return which will allow my client to live the lifestyle they desire.
Once this is known, I will begin with one of my model portfolios, and by running 1,000 or more trials with Monte Carlo simulation, I can forecast the probability of achieving this return for annual, five-year, and 10-year periods. It’s important to target an expected return which is higher than the required return. Let’s say the required return was 7.5%. If the expected return were the same, then I would likely have a 50/50 shot of success. Therefore, I target a return which is slightly higher than the required return so the probability of success will be higher.
Next week I’ll share how I build a portfolio which starts with the bond category. Stay tuned.
Entries (RSS)
This is exactly how financial planning is being used to over leverage and increase the risk by Wall Street. Is that even feasible that investmenting in riskier assets such as equities can produce a loss or no return over long period of time? Newsfalsh – yes it can. FP models are full of “it”, data inputs are insufficient to have predictive power, and current environment does not bode well for future returns. Increasing risk to ensure that clients are on the “path” to achieveing their returns will simply increase probability of devastating their nestegg. How about the approach of “do no harm first” and ensuring the portfolio is tactically tilted via a collection of strategies to produce optimal risk-adjusted return in current environment given the customer’s risk tollerance for a maximum drawdown. You or me or anyone else do not have a crystal ball, the best we can do is deliver returns which the market gives us with acceptable level of risk to our clients. We should not be managing money, we should be managing risk to that money when they are committed to certain asset classes in the asset allocation and instrumnets we advocate as investments. Markets do not care about us, our clients or their needs and goals in fact they will sacrifice exactly those who get fixated in a static investment platform. Even Noble laureates at LTC got their heads handed to them yet you pretend that your Monte Carlo simulation will produce a reasonably safe outcome. You seem to advocate driving forward by looking at the rear view mirror with this approach when it very well may be that the true answer to many of our clients will be save more, reduce your debt and accept lower returns that markets can generate for us for the next 10-20 years. Increasing risk exposure to increase desired returns may likely result in catstrophic result and is simply not worth the risk from the position in which we find ourselves in right now in global markets. Safe is better then sorry and no historic simualtion is a reasonable assumption in this context. Consistent current investment expertise and understanding of global markets is what customer’s should pay for not set in stone investment methods which allow for more time for advisors to sell and market looking for new victims of their naiviete. So far you’re doing what almost every “financial planner”, “advisor”, or “broker” is doing and has done and is the investment model from which clients are running away unfortunately most likely into the arms of similar set up. Hope is not a strategy for our industry or our clients, investment expertise and vigilant adjustments and timely recommendations are the way to preserve first and then grow second our clients assests based on their risk preference. How would you answer an objection such as this? MPT, CAPM or any other theoiries with clearly faulty assumptions are not the way to sell snow to this eskimo. Letting experts do this at an expense to you if you do not how is the right thing to do for the clients which will in turn allow you a legitimate competitive advantage in your sales and marketing effort not more of the same.
Rob – exactly! No discredit to Mike. I am a CFP and do not use Monte Carlo simulations (horrors!). I understand the simulations and the mathematics behind them, but do not know how, even with the vast data, you can say with any certainty what rate of return will occur in the future.
Look at the past 1, 3, 5 and 10 yrs. Using historical investment returns 1, 3, 5 or 10 yrs ago would have never resulted in what we’ve experienced. Ever. If someone were retiring 10 years ago and came to you for investment planning assistance, you would have been dead wrong based on what has happened.
I do use benchmark index returns but focus entirely on constructing a well diversified portfolio. I do not enter the guaranteed (what the client hears), er….target (what we mean) rate of return conversation with clients. I will not be held accountable to the market’s volatility.
The only way to manage a portfolio, in my opinion, is by creating a well diversified, allocated portfolio and adjusting based on moving time horizon and market environment – not backward looking stats.
Julie,
Thanks for your comments. For what it’s worth, I agree with your MCS concerns. I have found that you can run the same scenario through different financial planning software programs and get very different results. It’s the black-box-locked-down versions that are a concern to me. However, I use an add in to Excel entitled Crystal Ball which is sold by Oracle (they acquired Decisioneering, Inc. the original maker). With this, and after running 100’s of simulations, I am convinced that while it it not a panacea (nothing is), it provides a much better tool than the aforementioned products. I’m not sure where some of the assumptive comments come from, but I have never told clients that I can forecast future returns. To be sure, and according to William Sharpe, past returns have no predictive value (they are not serially correlated). Past risk does have predictive value (again, according to Sharpe). There, I NEVER USE historical returns in forecasting. I use a simple weighted average because no one knows what the future holds. The MCS forecasting is simply an improvement over a linear or deterministic forecast and that’s it! It would be hard to argue differently. Actually, MCS is nothing more than a risk management tool which is again, better than a static projection.
I hear advisors say, “I use a well diversified portfolio.” How do you define this, mathematically, that is? How do you know if it’s “well diversified?” Do you look backwards to see how it performed over difficult periods?
In any event, I appreciate the way you opened your comments. Shows me that you are probably open to constructive discussions.
Take care.