Comments on: How Real Returns Get in the Way of a Good Plan http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/ Moving beyond the basics Wed, 19 Nov 2008 15:58:13 +0000 http://wordpress.org/?v=2.2.2 By: EJD http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-3748 EJD Mon, 22 Oct 2007 21:38:28 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-3748 10 years is a rather short period over which to evaluate the differences. Also, one must look at the range of possible returns which is highly dependent on when the ups and downs occur in the time-frame. I don't get quite the same answers as posted for the investment value, but the relative differences between the actual and average values held true. To look at the potential range of values, run the same model using the same 10 years of interest rates, but order the returns in lowest to highest and highest to lowest. Ordering the returns from lowest to highest yields the highest possible final value, and you should find the value of the volatile to be rougly $30,000 higher than the "smooth" case. Ordering the returns from highest to lowest yields the lowest possible final value, and you should find the value of the volatile to be rougly $15,000 lower than the "smooth" case. The high and low potential values can be calculated this way over any time horizon. This still doesn't change the fact that no matter what projection method is used, it will be wrong. An overly simplified assessment of these numbers would be to assume that there is equal likelihood of any net asset value between the high and low at the end of the 10 year term. In that case, the expected, or average NAV in the volatile market would be expected to be (30,000-15000)/2 or $7500 MORE than the smooth projection. I think that the best that one can do is to run many permutations of actual investment returns (over many different periods of time as well) and histogram the results (also known as running market simulations). You can then look at as optimistic or pessimistic a view as you desire, and compute a probability that you will achieve any desired set of results. I.e. you will be able to say things like there's a 90% probability that my investments will be worth at least $XXX in 10 years. 10 years is a rather short period over which to evaluate the differences.
Also, one must look at the range of possible returns which is highly dependent on when the ups and downs occur in the time-frame.

I don’t get quite the same answers as posted for the investment value, but the relative differences between the actual and average values held true.
To look at the potential range of values, run the same model using the same 10 years of interest rates, but order the returns in lowest to highest and highest to lowest.

Ordering the returns from lowest to highest yields the highest possible final value, and you should find the value of the volatile to be rougly $30,000 higher than the “smooth” case.

Ordering the returns from highest to lowest yields the lowest possible final value, and you should find the value of the volatile to be rougly $15,000 lower than the “smooth” case.

The high and low potential values can be calculated this way over any time horizon. This still doesn’t change the fact that no matter what projection method is used, it will be wrong.

An overly simplified assessment of these numbers would be to assume that there is equal likelihood of any net asset value between the high and low at the end of the 10 year term. In that case, the expected, or average NAV in the volatile market would be expected to be (30,000-15000)/2 or $7500 MORE than the smooth projection.

I think that the best that one can do is to run many permutations of actual investment returns (over many different periods of time as well) and histogram the results (also known as running market simulations). You can then look at as optimistic or pessimistic a view as you desire, and compute a probability that you will achieve any desired set of results.
I.e. you will be able to say things like there’s a 90% probability that my investments will be worth at least $XXX in 10 years.

]]> By: KMC http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-520 KMC Mon, 27 Aug 2007 15:32:15 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-520 Bonnie, I didn't intend for this post to be a downer for anybody! My intent wasn't to mess up anyone's plan, just illustrate the effect of volatility. A projection that uses historical numbers is still probably valid as long as your time horizon is sufficiently long. Volatility really comes in to play right before retirement and in the first few years of retirement. I'm sure your plan is just fine. ;) You're way ahead just having a plan. Bonnie, I didn’t intend for this post to be a downer for anybody! My intent wasn’t to mess up anyone’s plan, just illustrate the effect of volatility.

A projection that uses historical numbers is still probably valid as long as your time horizon is sufficiently long. Volatility really comes in to play right before retirement and in the first few years of retirement.

I’m sure your plan is just fine. ;) You’re way ahead just having a plan.

]]> By: Bonnie http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-512 Bonnie Sat, 25 Aug 2007 02:03:51 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-512 This post gets my favorite vote for the week for sure. I have to echo Paidtwice and say that I too love my retirement projections a little less now. :) Now I am trying to figure out how to come up with more realistic projections. Any thoughts? Thank you so much for this post. Very helpful. This post gets my favorite vote for the week for sure. I have to echo Paidtwice and say that I too love my retirement projections a little less now. :) Now I am trying to figure out how to come up with more realistic projections. Any thoughts? Thank you so much for this post. Very helpful.

]]> By: KMC http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-505 KMC Fri, 24 Aug 2007 15:05:54 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-505 Bonnie, you are 100% right. I made a mistake that I've now corrected. Bonnie, you are 100% right. I made a mistake that I’ve now corrected.

]]> By: Bonnie http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-503 Bonnie Fri, 24 Aug 2007 14:02:27 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-503 This is a great help. Thanks for being so clear. I averaged the volatile side of your spreadsheet and came up with around 10%. Looks pretty much like what is regularly suggested by anyone talking about historical S&P. So, what do you do to work out this problem to come up with a more realistic number? This is a great help. Thanks for being so clear. I averaged the volatile side of your spreadsheet and came up with around 10%. Looks pretty much like what is regularly suggested by anyone talking about historical S&P. So, what do you do to work out this problem to come up with a more realistic number?

]]> By: Carnivals - Week of 8/20/07 - FinancialDominance.com http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-502 Carnivals - Week of 8/20/07 - FinancialDominance.com Fri, 24 Aug 2007 03:46:08 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-502 [...] Advanced Personal Finance shows you how real returns get in the way of a good plan [...] […] Advanced Personal Finance shows you how real returns get in the way of a good plan […]

]]> By: The Best of the Carnival of Personal Finance #114 » The Dough Roller http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-475 The Best of the Carnival of Personal Finance #114 » The Dough Roller Tue, 21 Aug 2007 00:12:19 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-475 [...] How Real Returns Get in the Way of a Good Plan @ Advanced Personal Finance: This is a good primer on how volatility impacts returns. [...] […] How Real Returns Get in the Way of a Good Plan @ Advanced Personal Finance: This is a good primer on how volatility impacts returns. […]

]]> By: The Simple Dollar » Carnival of Personal Finance #114 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-474 The Simple Dollar » Carnival of Personal Finance #114 Mon, 20 Aug 2007 13:35:03 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-474 [...] How Real Returns Get In The Way Of A Good Plan (@ advanced personal finance) [...] […] How Real Returns Get In The Way Of A Good Plan (@ advanced personal finance) […]

]]> By: Sunday Morning Link Love at I’ve Paid For This Twice Already… http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-472 Sunday Morning Link Love at I’ve Paid For This Twice Already… Sun, 19 Aug 2007 14:28:21 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-472 [...] very very favorite post this week comes from Advanced Personal Finance. I love numbers! How real returns get in the way of a good plan talks about how volatile returns and smooth returns are not the same thing. And when you average an [...] […] very very favorite post this week comes from Advanced Personal Finance. I love numbers! How real returns get in the way of a good plan talks about how volatile returns and smooth returns are not the same thing. And when you average an […]

]]> By: Aaron http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-445 Aaron Wed, 15 Aug 2007 01:05:58 +0000 http://advancedpersonalfinance.com/how-real-returns-get-in-the-way-of-a-good-plan/#comment-445 Good point. A large amount of people don't understand this point at all so it is a very good post that a lot of people should read. Both good returns, but the smooth return is certainly better. Good point. A large amount of people don’t understand this point at all so it is a very good post that a lot of people should read. Both good returns, but the smooth return is certainly better.

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