Investment returns vary from year to year, and although the return does have a long-term average, account balances rise and fall as the market changes from year to year. MaxiFi’s Living Standard Monte Carlo risk analysis will help you understand how this annual variation impacts your annual living standard and discretionary spending. The Living Standard Monte Carlo helps you to see if you are taking too much risk, more risk than you need to, or perhaps too little risk with your investments as you explore different investment strategies and spending behavior settings. For a discussion of sequence of returns risk, see this case study.
The explanation below focuses on how to set up MaxiFi's Monte Carlo analysis. For more detail about the Monte Carlo concepts in MaxiFI, see How does Monte Carlo Risk Analysis work?
You can read this page to learn more about deterministic and stochastic planning approaches and how they work in MaxiFi Planner.
To begin, after opening the application and entering your data, navigate to Dashboard and Reports and choose to run the Risk Analysis report. From here, the easiest way to begin is to just select preset investment strategies for your Base Strategy (MaxiFi automatically sets up two default alternatives—"Safe" and "Risky"—to compare with your Base Strategy). Using this quick start approach, you choose from among our group of common investment strategies—for example, "Always Conservative" or "Always Moderate"—and use the drop down selectors to assign an investment strategy for each of three pools of money:
- Regular Assets
- Retirement Assets (spouse/partner)
- Retirement Assets (spouse/partner).
This approach is a quick way to get started, and once you see a report you can come back and fine tune things later. To view the asset allocation that makes up these strategies, click the "view detail" link below the strategy. Once you have selected your investment strategies, you are ready to proceed to the next screen and set spending behavior.
Creating Custom Assets and Investment Strategies
If you want to build custom assets and investment strategies, use the "manage assets" and "manage investment strategies" links on the Risk Analysis setup screen. An asset is anything with a return history such as a mutual fund, an ETF, or some other stock, bond, commodity etc. position. An investment strategy is an asset or group of assets allocated in some proportion of 100% such as 60/40 or 60/20/20, etc. and assigned to one of the three groups of assets listed above. An investment strategy can be built to remain constant or change over time. So you start with assets (use those supplied or build your own) and combine them into investment strategies and then assign them to Base, Safe, or Risky strategies. Note that you can exclude the Safe and Risky strategy if you want to simplify things even more.
The easiest way to create a custom investment strategy is to start by customizing an existing strategy and adjust percentages, ages, and assets in the strategy rather than starting from scratch. To create a custom asset, you will need at least 10 years of return history on your asset. Help instructions in this area will guide you in creating your custom assets and strategies. Some users retrieve their return histories using "backtest portfolio" at Portfolio Visualizer or retrieve them from their brokerage account.
Setting up Spending Behavior
This next screen asks you to set up your spending behavior. This setting is important because how you spend each year relative to the actual returns you get in the market (for better or for worse) can have an important impact on your planning model. Cautious spending (spending in a way that assumes your rate of return will be less than expected) can provide a hedge against the risk of an aggressive asset allocation. Appropriate spending behavior (for example, spending as if your rate of return will be lower than the historical average) is just as important as appropriate asset allocation, a principle that conventional Monte Carlo ignores. You can learn more about spending behavior here.
The settings on the spending behavior page ask you to indicate for each strategy—base, safe, and risky (default labels you can edit)—what you want to describe and set as a "safe rate of return." This setting describes your "as if" return or spending behavior, not your return rates on your assets. In other words, even though you may be aware that historically your average rate of return is 7% or 9% based on your asset allocation, you may want to set your return rate for spending, this as if rate, as if you are only earning an average a 1.5% return. This spending approach would be an example of building a model that approaches each year "cautiously" relative to your anticipated return. You could also do the opposite and model aggressive "as if" spending. Your assumptions about safe rate of return do not need to be the same as your investment strategy. Indeed, it has been said: "if you invest aggressively, you should spend cautiously; if you invest cautiously, you can spend aggressively." Trying different combinations of investment strategies and spending behaviors is a way to learn about their importance to your particular planning model. It is reasonable to assume the same spending behavior for each of the three investment strategies as a place to begin and establish a benchmark for comparison.
The two distribution charts seen here illustrate the same investment strategy but with different assumptions about spending behavior. The one that tips upward reflects a conservative spending behavior and the one that tips downward reflects an aggressive spending behavior.
A thorough risk analysis is not just about statistics of risk and reward but also about the subjective sense of whether the reward is worth the risk, and every person has his or her own sense of that trade off. The Index of Expected Lifetime Utility includes this subjective and personal sense of whether a risk is worth it in this risk analysis. To use this chart, you first self-identify with one of the five five column descriptions. Then choose the row with the highest utility for your risk tolerance. In the chart below, the Safe Strategy provides on average a 3% higher lifetime utility-- a living standard is equal to what you'd get in the base case strategy but also be able to consume 3% more consumption equivalent. The chart gives general guidance on which strategy would provide the highest expected utility or happiness given your risk tolerance. You would not compare columns, but only rows within the column you choose.
The following video will provide a general overview Monte Carlo and in particular of the expected utility function beginning at 9:10 minute into the video.