How I Use Financial Projections to Shape Investment Strategy

“…it’s as if there is 30 seconds left in the game, you have the ball and are up by a field goal. All you have to do is take a knee to win. But, instead, you’re trying to score another touchdown.”

Background

The most important investment decision you can make is how much to allocate between major asset classes: bonds, stocks, commodities and real estate.

This decision alone drives the vast majority of risk and return experienced in a portfolio and, therefore, can have a tremendous impact on financial outcomes for most households.

Therefore, the majority of our time should be spent on this allocation decision. Additionally, this decision needs to be periodically evaluated.

Instead, most retail investors (and some advisors) spend the majority of their time trying to figure out which stock to buy, as an example.

Additionally, because this allocation decision is such an important driver of financial outcomes, we must pursue a consistent, methodical, thoughtful process for making the most informed choice possible.

I’ve seen many advisors / advisory firms put very little thought into this decision without using a methodical process. Many advisors simply use a “risk tolerance questionnaire” (which are not very useful at all) or generic rules of thumb or just kind of put their finger to the wind loosely based on things like client age or a client’s self-reported risk tolerance.

So, here I am going to share a case study that gives insight into my process for identifying the optimal investment strategy.

We must first acknowledge that the primary objective of saving and investing throughout our lives and hiring a financial advisor, etc… is to maximize our probability of becoming and remaining financially independent.

That may seem obvious, but too many folks assume and/or act as if the primary objective is to maximize portfolio returns at all costs!

Therefore, part of my job is not to maximize returns but to maximize probabilities of success across a variety of economic and market outcomes. This is a very important distinction.

The Process

I use a financial planning software called MoneyGuidePro. Many other firms use this software as well, but I think I use it differently than many.

I will reference an actual client situation to illustrate the process.

The first thing I do with any new client is prepare a baseline scenario of financial projections, which includes everything AS IS. This baseline helps to identify any obvious, immediate red flags.

In the case of this client, their initial baseline scenario resulted in a 97% probability of success even using conservative assumptions. Fantastic!

At a glance it appears they’re in great shape. The program ran 1,000 different trials and they only ran out of money prematurely in 3%, or 30, of those.

That loosely means that if 1,000 households had these same circumstances and never revisited their plan again simply letting inertia carry them through to death that only 30 of those households would have run out of money prematurely.

What it practically means for one of my clients for whom we’re proactively updating these projections each year is that there is a 3% chance we may need to make an adjustment (typically a spending reduction) at some point in time.

But, of course, that’s just a baseline. We need to stress test these results against other unexpected events to see if we have any blind spots. This is where the rubber meets the road.

Some stress tests that are often appropriate are: premature death, long-term disability, long-term care need in retirement, higher than expected inflation, worse than expected portfolio returns, etc…

But the one I’m focusing on here is the market stress test. In this test, I force an immediate stock market decline into a scenario resulting in a corresponding drawdown of the portfolio. In other words, we’re testing “Sequence of Returns Risk,” which I wrote about here previously.

So, the second scenario I build in the projections simulates a 60% decline in the U.S. stock market and 5% increase in bonds. However, since this client owns 100% stocks anyway the corresponding hypothetical portfolio decline is 60%.

The resulting probability of success drops to 49% from 97% as a result of an immediate stock bear market! Far below my comfort zone for somebody of this age nearing retirement.

Now that we are aware of this threat to financial independence, our next step is to calculate results of new scenarios with different investment allocations and then stress test those to back into the most appropriate strategy.

If we adjust the portfolio to target 50% in “risk assets” (stocks, commodities, real estate) down from 100% stock exposure, we actually INCREASE the probability of success from 97% to 99% even though the long-term expected returns are lower!

Then, when I simulate the same bear market stress test on the 50/50 portfolio where bonds make 5% and stocks lose 60%, even when adjusting for lower returns going forward, the probability of success remains at 98% versus 49%!

In this particular case by simply adjusting the investment allocation we are dramatically improving the likelihood of remaining financially independent / minimize adjustments even in the face of a near-term severe market downturn.

As I told the client, it’s as if there is 30 seconds left in the game, you have the ball and are up by a field goal. All you have to do is take a knee and you win the game. But, instead, you’re trying to score another touchdown. Take the knee. Enjoy your financial independence.

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