Spare those Busted Models and go Grillo Style

Spare those Busted Models and go Grillo Style to see Sara’s live demolition of a busted Monte Carlo model.

Come on Gen X, let’s get real. I’m not a big fan of those lofty, bookish, geek-touted financial models – and my least favorite model is Monte Carlo Simulation. In plain terms, here’s what a Monte Carlo Simulation is. It’s named after a city in Monaco where people gamble because that’s exactly what it does; it projects your wealth based risk, chance, and randomness. It takes a scenario, such as your $250k savings growing at a 5% return, and then shakes, rattles, and rolls it several times. These are called trials. The trials show different outcomes based on the random variables, or “shocks” that the model incorporates into each trial. For example, one trial may assume that inflation sharply rises.

A probability distribution of the outcome of these trails is what the financial advisor presents to you as the estimation of your future wealth. People buy it because they trust the advisor, but most of the time the person explaining it to you hasn’t take the time to understand the random variables used in the model, or thought about if those assumptions are relevant to your particular life.

Financial adviser laziness is only one of the reasons why a Monte Carlo Simulation should not be trusted. Models are depictions of reality – but they are not reality, especially ones that are complex, highly statistical, and rely on a large set of assumptions about events occurring over long periods of time. Small inaccuracies are magnified over long periods of time because the error becomes compounded each year. I’m skeptical any time a model projects an event or a figure over a period of longer than five years.

Money is personal and people get emotional about it. Such models do not account for emotional events, such as panic withdrawals. A Monte Carlo doesn’t take into account the response that the person will have towards interim outcomes along the way. The analysis may rely on the assumption that you’ll have a loss 15 years out of the next 45. Well, how many people are really going to put up with it if three of those losses occur in three consecutive years? They’d pull their money out of the market so fast! Models like this are worthless because they don’t account for investor psychology which plays a huge part every step of the way. Monte should be used for projections of things where people’s emotions aren’t involved.

My advice is to rip up that Monte analysis and throw it in the trash can. Then, do the following. Ask yourself these four questions:

What is my net worth (assets minus liabilities) as of today? (Believe it or not, many people don’t have a clue what their net worth is – especially in Gen X!)
At what age do I want to retire? Now, some Gen X people say, “Sara, I love work! I never want to retire! I’m going to work until I die!” You can’t control everything. You may wear out due to issues beyond your control, issues you may not imagine when you are a healthy 35 years old. Assume that you will retire at some point (just at a later age if you like working that much.)
How much money I need to have in order to retire at that time?
What could possibly go wrong to prevent me from achieving this goal?
In regards to answering Question #3, if you decide to take higher risk, ask yourself these questions.

What would an aggressive portfolio have done in the years 2007 and 2008?
Is a double digit negative return going to put me in a bad mood so that I snap at my family, friends, and coworkers until the market comes back?
Am I going to panic and withdraw money if my portfolio goes down 20%?
What did I do with my portfolio in the years 2007-2008 when the market was volatile? Would I do that again? (Hey folks, remember that past behavior is the best prediction of your future behavior in times these instances.)
Let’s spare ourselves the bells and whistles and get back to basics. I favor an approach that focuses on liabilities not assets. My approach would be this:

  1. Look at what you’re going to be on the hook for paying over the next 35-40 years, and then figure out how much you need to make in income to pay that.
  2. Figure out what the lowest possible amount for each liability might be, and the highest possible amount for each liability might be.
  3. Calculate what the total liability amount is projected by the time you retire both for the low and high scenarios

Then, given your income and net worth, figure out how much that means you need to save in order to achieve a level of wealth that matches your goals. Do this for both scenarios.As Gen Xers, we’ve got control of our income, our savings, and if you’re starting to save and invest in your 20′s or 30′s, you’ve taken control of time. Anyone reading this post should tweet to me @saragrillo3 if they have opinions about the down to earth Grillo way to project your retirement savings.


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