0
January 2008
<ul><li>Retirement   </li></ul><ul><li>Scenario and Pitfalls </li></ul><ul><li>Back-test Monte Carlo simulation (1926-2005...
<ul><li>Past performance is no guarantee of future returns </li></ul><ul><li>Investor returns may be worth more or less th...
<ul><li>Assumptions </li></ul><ul><li>Large Cap Stocks: 1926-2005 </li></ul><ul><li>Bonds: 1926-2005 </li></ul><ul><li>Nes...
<ul><li>19.6% chance of running out of money within 30 years </li></ul>Copyright 2008 Dennis Foley Monte Carlo is superior...
<ul><li>Fixed withdrawal remains at 4.5%, but reduce yearly increase (for inflation) from 3% to 2% per year </li></ul><ul>...
<ul><li>Average less than 1% delta to historical data </li></ul><ul><li>Proves validity of this Monte Carlo model </li></u...
<ul><li>Age 45 => 20 years from retirement </li></ul><ul><li>$175K nest egg </li></ul><ul><li>Goal of $1KK with  > 75% cer...
<ul><li>Need to increase yearly savings to $12,500/year to meet goal </li></ul>Copyright 2008 Dennis Foley
Copyright 2008 Dennis Foley
<ul><li>Stocks </li></ul><ul><li>Bonds </li></ul><ul><li>Real Estate </li></ul><ul><li>Cash </li></ul><ul><li>All 4 groups...
<ul><li>Small cap stocks offer 2.2% greater average return than large cap stocks </li></ul><ul><li>But, with more than a 5...
Copyright 2008 Dennis Foley Assume: $1K initial and $1K/year for 5 years
<ul><li>Large Cap has less chance losing money </li></ul><ul><ul><li>Large Cap = 18.1% chance of less than $6K </li></ul><...
<ul><li>Actively managed mutual funds offer endless combinations of stock/bond subgroups </li></ul><ul><li>Actively manage...
<ul><li>In the last 5 years: </li></ul><ul><ul><li>S&P index has outpaced 67% large cap actively managed Mutual Funds </li...
<ul><li>You don’t need a financial advisor </li></ul><ul><li>You don’t need actively managed funds </li></ul><ul><li>It is...
Copyright 2008 Dennis Foley
<ul><li>Assumption: historical data from 1926-2005 </li></ul>Copyright 2008 Dennis Foley
<ul><li>Historical fit of Gold 1986-2006 </li></ul><ul><li>Data fit from historical returns </li></ul><ul><li>Non symmetri...
Copyright 2008 Dennis Foley
<ul><li>Simplification of Modern Portfolio Theory </li></ul><ul><li>1990 Nobel Prize Harry Markowitz et. al. </li></ul><ul...
Copyright 2008 Dennis Foley
Copyright 2008 Dennis Foley
<ul><li>Can run the math… or let Crystal Ball do it for you! </li></ul>Copyright 2008 Dennis Foley
<ul><li>What happens if correlation coefficient 1? </li></ul><ul><ul><li>Example (assume correlation coefficient = 1): </l...
Copyright 2008 Dennis Foley
<ul><li>Can do the math or let Crystal Ball (must enter correlation) </li></ul>Copyright 2008 Dennis Foley
Copyright 2008 Dennis Foley
<ul><li>Expected value is a linear operator </li></ul><ul><ul><li>Just weighted average </li></ul></ul><ul><li>Standard de...
<ul><li>Summary  </li></ul><ul><ul><li>Diversification optimizes your portfolio – provided that correlation coefficient ar...
<ul><li>Correlation Coefficients can change over time! </li></ul><ul><ul><li>International stocks used to have a low corre...
<ul><li>The only proven method to wealth is to  save </li></ul><ul><li>Index Funds/ETF’s provide better returns than activ...
<ul><li>Saving for Retirement </li></ul><ul><ul><li>Determine % certainty requirement </li></ul></ul><ul><ul><li>Determine...
<ul><li>Retirement Withdrawal </li></ul><ul><ul><li>Determine your goals: </li></ul></ul><ul><ul><ul><li>Amount of time yo...
Copyright 2008 Dennis Foley
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Applying Stats To Financial Planning 97 2003

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Use Crystal Ball Monte Carlo simulation software to improve your 401K investment decisions

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  • Measurement data are used more often and in many more ways today than in the past. Measurement data is used today to: -Monitor manufacturing processes -Monitor product quality -Determine corrective actions to take -Adjust manufacturing processes -Determine if relationships exist between variables -Model new systems The quality of the data from our measurement devices is critical to good decision making. This is the reason for Gage Studies, or Measurement Systems Analysis. There are several types of gage studies that we can perform, depending on the type of data and the method that the data is gathered.
  • Transcript of "Applying Stats To Financial Planning 97 2003"

    1. 1. January 2008
    2. 2. <ul><li>Retirement </li></ul><ul><li>Scenario and Pitfalls </li></ul><ul><li>Back-test Monte Carlo simulation (1926-2005) </li></ul><ul><li>More retirement scenarios (audience participation) </li></ul><ul><li>Normal distributions and best fit of historical data </li></ul><ul><li>Savings </li></ul><ul><li>Time horizon </li></ul><ul><li>Modern Portfolio Theory </li></ul><ul><li>Diversification </li></ul><ul><li>Appetite for risk </li></ul><ul><li>Fitting gold, individual stock, or other investments </li></ul><ul><li>Running your own forecast scenarios </li></ul>Copyright 2008 Dennis Foley
    3. 3. <ul><li>Past performance is no guarantee of future returns </li></ul><ul><li>Investor returns may be worth more or less than original cost </li></ul><ul><li>“ Back tested” this Monte Carlo model is correct over 99% of the time from 1926 through 2005 </li></ul><ul><li>No one really knows what will happen in the future (including me, your broker, financial advisor, barber, guy at work, actively managed mutual fund manager, etc.) </li></ul>Copyright 2008 Dennis Foley
    4. 4. <ul><li>Assumptions </li></ul><ul><li>Large Cap Stocks: 1926-2005 </li></ul><ul><li>Bonds: 1926-2005 </li></ul><ul><li>Nest egg at retirement = $1KK base in 2007 </li></ul><ul><li>4.5% fixed withdrawal ($45,000) </li></ul><ul><li>Increased by fixed 3% per year (for inflation) </li></ul><ul><li>80% stocks (avg.=10.4%, standard dev.=20.2%) </li></ul><ul><li>20% bonds (avg.=5.5%, standard dev.=5.55%) </li></ul><ul><li>No adjustment in stock/bond ratio over time </li></ul>Copyright 2008 Dennis Foley
    5. 5. <ul><li>19.6% chance of running out of money within 30 years </li></ul>Copyright 2008 Dennis Foley Monte Carlo is superior than classical “point” estimates.
    6. 6. <ul><li>Fixed withdrawal remains at 4.5%, but reduce yearly increase (for inflation) from 3% to 2% per year </li></ul><ul><li>Change stock percentage to 22.8% </li></ul><ul><li>3.7% chance of running out of money within 30 years </li></ul>Copyright 2008 Dennis Foley With minor adjustments, increase certainty of not running out of money from 80.4% to 96.3%
    7. 7. <ul><li>Average less than 1% delta to historical data </li></ul><ul><li>Proves validity of this Monte Carlo model </li></ul>Copyright 2008 Dennis Foley
    8. 8. <ul><li>Age 45 => 20 years from retirement </li></ul><ul><li>$175K nest egg </li></ul><ul><li>Goal of $1KK with > 75% certainty in 20 years </li></ul><ul><li>Previously determined to use: </li></ul><ul><ul><li>2008 – 75% stocks, 25% bonds linearly reduce to… </li></ul></ul><ul><ul><li>2028 – 45% stocks, 55% bonds </li></ul></ul><ul><li>Contribute $10K/year </li></ul><ul><li>How much should contribution be reduced or increased to achieve at least $1KK with 75% certainty?? </li></ul>Copyright 2008 Dennis Foley
    9. 9. <ul><li>Need to increase yearly savings to $12,500/year to meet goal </li></ul>Copyright 2008 Dennis Foley
    10. 10. Copyright 2008 Dennis Foley
    11. 11. <ul><li>Stocks </li></ul><ul><li>Bonds </li></ul><ul><li>Real Estate </li></ul><ul><li>Cash </li></ul><ul><li>All 4 groups have sub-groups with various benefits and risks… but this is pretty much the investment universe! </li></ul>Copyright 2008 Dennis Foley
    12. 12. <ul><li>Small cap stocks offer 2.2% greater average return than large cap stocks </li></ul><ul><li>But, with more than a 50% increase in dispersion versus large cap stocks </li></ul><ul><li>What does this mean? </li></ul><ul><li>Assume: $1K initial and $1K/year for 5 years </li></ul><ul><li>Run Monte Carlo to see… </li></ul>Copyright 2008 Dennis Foley
    13. 13. Copyright 2008 Dennis Foley Assume: $1K initial and $1K/year for 5 years
    14. 14. <ul><li>Large Cap has less chance losing money </li></ul><ul><ul><li>Large Cap = 18.1% chance of less than $6K </li></ul></ul><ul><ul><li>Small Cap = 28.2% chance of less than $6K </li></ul></ul><ul><li>Small Cap has greater chance of upside </li></ul><ul><ul><li>Large Cap = 2.9% chance of more than $12K </li></ul></ul><ul><ul><li>Small Cap = 13.2% chance of more than $12K </li></ul></ul><ul><li>Investors must decide if they want greater upside or less downside… </li></ul>Copyright 2008 Dennis Foley Assume: $1K initial and $1K/year for 5 years
    15. 15. <ul><li>Actively managed mutual funds offer endless combinations of stock/bond subgroups </li></ul><ul><li>Actively managed funds (vs. index funds) </li></ul><ul><ul><li>Have much higher tax rates (fund turnover) </li></ul></ul><ul><ul><li>Have much higher expenses (1.5% vs. 0.25%) </li></ul></ul><ul><ul><li>Sometimes have loads as high as 5%! </li></ul></ul><ul><li>Index funds offers superior long term returns </li></ul>Copyright 2008 Dennis Foley
    16. 16. <ul><li>In the last 5 years: </li></ul><ul><ul><li>S&P index has outpaced 67% large cap actively managed Mutual Funds </li></ul></ul><ul><ul><ul><li>With no advice! </li></ul></ul></ul><ul><ul><li>S&P mid cap index has outpaced 84% of actively managed mid cap funds </li></ul></ul><ul><ul><ul><li>With no financial planning! </li></ul></ul></ul><ul><ul><li>S&P small cap index has outpaced 79% of actively managed small cap funds </li></ul></ul><ul><ul><ul><li>With minimum tax consequences </li></ul></ul></ul>Copyright 2008 Dennis Foley
    17. 17. <ul><li>You don’t need a financial advisor </li></ul><ul><li>You don’t need actively managed funds </li></ul><ul><li>It is relatively easy to “do it yourself” </li></ul><ul><li>You will save more money </li></ul><ul><li>If retired, you will have more money to withdraw </li></ul><ul><ul><li>Depending on the size of your nest egg…. </li></ul></ul><ul><ul><li>It may be as much (or more) than a car payment </li></ul></ul><ul><li>You run Monte Carlo simulations to optimize your portfolio </li></ul><ul><li>All that you need is the software and a PC </li></ul>Copyright 2008 Dennis Foley
    18. 18. Copyright 2008 Dennis Foley
    19. 19. <ul><li>Assumption: historical data from 1926-2005 </li></ul>Copyright 2008 Dennis Foley
    20. 20. <ul><li>Historical fit of Gold 1986-2006 </li></ul><ul><li>Data fit from historical returns </li></ul><ul><li>Non symmetrical </li></ul>Copyright 2008 Dennis Foley
    21. 21. Copyright 2008 Dennis Foley
    22. 22. <ul><li>Simplification of Modern Portfolio Theory </li></ul><ul><li>1990 Nobel Prize Harry Markowitz et. al. </li></ul><ul><li>All investments can be assigned </li></ul><ul><ul><li>Expected value </li></ul></ul><ul><ul><li>Standard deviation (dispersion) </li></ul></ul><ul><ul><li>Correlation* </li></ul></ul><ul><li>Diversification leads to less risk => higher return </li></ul><ul><ul><li>*Models shown so far have correlation = 0 </li></ul></ul><ul><ul><ul><ul><li>Crystal Ball allows setting correlation values </li></ul></ul></ul></ul>Copyright 2008 Dennis Foley
    23. 23. Copyright 2008 Dennis Foley
    24. 24. Copyright 2008 Dennis Foley
    25. 25. <ul><li>Can run the math… or let Crystal Ball do it for you! </li></ul>Copyright 2008 Dennis Foley
    26. 26. <ul><li>What happens if correlation coefficient 1? </li></ul><ul><ul><li>Example (assume correlation coefficient = 1): </li></ul></ul><ul><ul><li>Portfolio = 50% Fund A and 50% Fund B </li></ul></ul><ul><ul><li>Fund A Past/Expected Return = 20% </li></ul></ul><ul><ul><li>Fund A historical standard deviation = 26% </li></ul></ul><ul><ul><li>Fund B Past/Expected Return = 10% </li></ul></ul><ul><ul><li>Fund B historical standard deviation = 16% </li></ul></ul><ul><ul><li>Portfolio Expected Return = ? </li></ul></ul><ul><ul><li>Portfolio Expected standard deviation = ? </li></ul></ul>Copyright 2008 Dennis Foley
    27. 27. Copyright 2008 Dennis Foley
    28. 28. <ul><li>Can do the math or let Crystal Ball (must enter correlation) </li></ul>Copyright 2008 Dennis Foley
    29. 29. Copyright 2008 Dennis Foley
    30. 30. <ul><li>Expected value is a linear operator </li></ul><ul><ul><li>Just weighted average </li></ul></ul><ul><li>Standard deviation is </li></ul><ul><ul><li>Square Root of (Weighted average of the variance + covariance) </li></ul></ul><ul><ul><li>Can do the math </li></ul></ul><ul><ul><li>Or just use Crystal Ball! </li></ul></ul><ul><li>Diversification among uncorrelated assets: </li></ul><ul><ul><li>Higher return with less risk! </li></ul></ul><ul><ul><li>“ Efficient Frontier” </li></ul></ul>Copyright 2008 Dennis Foley
    31. 31. <ul><li>Summary </li></ul><ul><ul><li>Diversification optimizes your portfolio – provided that correlation coefficient are less than 1 </li></ul></ul><ul><ul><li>Pick stocks, funds or ETF’s that are not correlated </li></ul></ul><ul><ul><li>Typical asset classes with low correlation coefficients to each other </li></ul></ul><ul><ul><ul><li>Cash </li></ul></ul></ul><ul><ul><ul><li>Bonds </li></ul></ul></ul><ul><ul><ul><li>Stocks </li></ul></ul></ul><ul><ul><ul><li>REIT’s </li></ul></ul></ul><ul><ul><ul><li>Emerging International </li></ul></ul></ul>Copyright 2008 Dennis Foley
    32. 32. <ul><li>Correlation Coefficients can change over time! </li></ul><ul><ul><li>International stocks used to have a low correlation coefficient </li></ul></ul><ul><ul><li>Now, with globalization, correlation coefficient to US indexes near 1.0! </li></ul></ul><ul><ul><li>Need to follow trends and periodically adjust </li></ul></ul><ul><ul><ul><li>Recent data suggests that international emerging markets have lower correlation coefficient to US markets </li></ul></ul></ul>Copyright 2008 Dennis Foley
    33. 33. <ul><li>The only proven method to wealth is to save </li></ul><ul><li>Index Funds/ETF’s provide better returns than actively managed funds </li></ul><ul><li>Crystal Ball/Monte Carlo can show: </li></ul><ul><ul><li>The risk of running out of money </li></ul></ul><ul><ul><li>The probability of saving enough </li></ul></ul><ul><ul><ul><li>With periodic saving </li></ul></ul></ul><ul><ul><ul><li>Depending on portfolio mix </li></ul></ul></ul><ul><ul><li>The optimized portfolio given your risk tolerance </li></ul></ul>Copyright 2008 Dennis Foley
    34. 34. <ul><li>Saving for Retirement </li></ul><ul><ul><li>Determine % certainty requirement </li></ul></ul><ul><ul><li>Determine Lump Sum desired </li></ul></ul><ul><ul><li>Use Monte Carlo to determine </li></ul></ul><ul><ul><ul><li>Probability of reaching Lump Sum </li></ul></ul></ul><ul><ul><ul><li>Extra Savings necessary to achieve goal </li></ul></ul></ul><ul><ul><ul><li>Optimal portfolio mix </li></ul></ul></ul>Copyright 2008 Dennis Foley
    35. 35. <ul><li>Retirement Withdrawal </li></ul><ul><ul><li>Determine your goals: </li></ul></ul><ul><ul><ul><li>Amount of time you want money to last (i.e. 30 years) </li></ul></ul></ul><ul><ul><ul><li>% probability of running out of money </li></ul></ul></ul><ul><ul><li>Run Monte Carlo to determine: </li></ul></ul><ul><ul><ul><li>Optimal portfolio mix </li></ul></ul></ul><ul><ul><ul><li>Withdrawal amount </li></ul></ul></ul><ul><ul><ul><li>Withdrawal yearly “raise” for inflation </li></ul></ul></ul>Copyright 2008 Dennis Foley
    36. 36. Copyright 2008 Dennis Foley
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