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MONEY$T YLE
HAPPY RETURNS WHERE THE ART OF THE POSSIBLE MEETS THE ART OF THE PROBABLE BY BRAD MCPHEE
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hen you devise a financial plan, it shouldn’t just forecast but also show probability. Unless, of course, you think money will just fall from the sky. Then you just need another set of rose-coloured glasses, lest you break the ones you’re wearing. After all, you look marvellous in pink! Often in the financial services industry, it is easy to make the numbers “work” simply by adjusting this or slightly lowering that. It is not beneficial, however, for me to tweak my clients plans so that they always work. It is simply not providing them the best advice. If things are not going well, then my clients need to know it. I don’t want to scare people, but I do want to tell them the chances of their success. That’s my job: to support people in making sound financial choices based on affordability, risk tolerance and probability. There’s a sophisticated analytical tool I use in financial modelling called Monte Carlo Analysis. It helps me to understand whether or not my clients are taking more risk than they need to. It helps to analyze volatility and also dramatically displays how different asset mixes (think stocks versus real estate) can reduce the chance of meeting important goals—such as ensuring they don’t outlive their money, a major concern among Canadians today. It is also a valuable check and balance on me and my ability to create the right strategies for my clients. You see, without a Monte Carlo analysis, you may not know that your financial advisor is showing you a scenario with a less than 10 per cent probability of success. Sure it could happen but that is not what most of us want to know. We expect and want to know the probability of our success, and in my opinion Monte Carlo is the best tool for the job. So how does it work? In all financial plans we make assumptions. If, for example, you’re using any one of a number of popular consumer budgeting and net-worth software
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products, you enter data and the software will run out your scenario. That is, it extends the numbers and does simple calculations. We look at the end result and feel confident we can achieve it. The problem is that life has many ups and downs and the chances of us successfully predicting outcomes years into the future are unlikely at best and even less accurate the further out the forecast extends. A good financial plan is modelled until the last spouse is deceased, sometimes beyond if we’re transitioning an estate to children. It must take into account many unknowns: Will we lose our job; develop a disability; see the highest market returns in history or a “lost decade”; retire during a huge recession; or use cash from a life-insurance policy to phase into our retirement. Yes, there is much to consider. Monte Carlo runs random scenarios and plots them based on all the information I’ve entered into my clients personalized strategic financial plan. Monte Carlo has broad use in many fields of science, medicine and transportation. It had a somewhat sinister origin, though: to evaluate the effect of the atomic bomb. It is particularly helpful in complex situations, such as the building of a skyscraper, with many people engaged and numerous materials required. Because our financial lives are like huge, complex, multiyear projects, Monte Carlo is a natural for use in our financial planning, as well. All analysis tools require an advisor who knows how to use them. The best way to test that is to ask him or her to explain the report—not just
throw out some final number on probability. For example, your life expectancy should be randomized (what happens if they discover a cure for the cancer you have not even developed yet). Your full deficit coverage should be forced (read: all debts have to be paid). And finally, make sure the advisor is running at least 500 random scenarios (I personally use 1,000) and not just the standard 100. The more scenarios, the more likely the probability. If your home-based software runs only one scenario, probability is virtually unknown. In summary, make sure that you’re evaluating the probability of your financial success not just reviewing a forecast of it. The best way to do that is with sophisticated modelling tools with a trained professional. Choose an advisor who wants to provide you a more realistic measure of risk and return. We may have to take risks in the modern financial world, but we can mitigate them by good, sound analysis of the probability of our success.
Brad McPhee is a Vancouverbased consultant with Investors Group and past chair of the Gay and Lesbian Association of BC. Views expressed in Money$tyle are solely McPhee’s. Outlooks, as well as Investors Group and its affiliates are not responsible and cannot accept any liability. The column is intended as a source of information and not a solicitation to buy or sell investments, nor to provide investment, financial, legal, accounting, tax or other professional advice. If you have a personalfinance question, email it to editor@ outlooks.ca.