Planning to drive a Monte Carlo

By Dan Bortolotti and Canadian Couch Potato on January 31, 2013
Estimated reading time: 3 minutes

I've tried to stress that investing is not about choosing the right products. ETFs changed the game by giving the little guy sophisticated and low-cost investment tools—no doubt about that. But the fact is, whether you choose this fund from iShares or that one from Vanguard will likely have zero impact on your overall success.

One of the lessons I’ve tried to stress is that investing is not about choosing the right products. ETFs changed the game by giving the little guy sophisticated and low-cost investment tools—no doubt about that. But the fact is, whether you choose this fund from iShares or that one from Vanguard will likely have zero impact on your overall success. That’s why I was pleased to read Chapter 4 of Larry Swedroe’s new book, Think, Act, and Invest Like Warren Buffett. The chapter is called “The Need to Plan: It’s Not Only About Investments,” and it explains why we need to look at the bigger picture. “There is evidence showing the biggest drivers are your spending rate, your savings rate, and how long you work,” Swedroe told me in a recent interview. “They influence the outcome far more than an extra 1% return you might get if you are a brilliant investor—and we know active investors would kill for 1% or 2% of alpha. When you run a Monte Carlo you can see how much more important these factors are.”

What’s a Monte Carlo?

Running a Monte Carlo doesn’t mean driving a classic Chevy coupe. Swedroe is referring to software used by financial planners to estimate the probability of meeting one’s goals. “I don’t know how you make any investment decisions without running Monte Carlos,” says Swedroe, “because otherwise you’re just pulling numbers out of your behind and guessing at the right asset allocation.” Let’s say you want to know if a $500,000 portfolio will last for 30 years after you retire. A host of factors will have an influence, including how much you spend, the inflation rate, and the volatility and expected returns of your investments. Remember, even if you’re confident stocks will deliver 7% to 8% annualized over 30 years, it won’t be a smooth ride, and the sequence of returns matters a lot. If a devastating bear market comes near the end of your life, you’ll probably be fine. But if it comes shortly after you retire, you might never recover from the losses, and you risk outliving your money. Monte Carlo software can take all of these variables and run thousands of simulations on your $500,000 portfolio over 30 years. It will estimate the odds your nest egg will endure if it is invested in, for example, 50% stocks and 50% bonds and you withdraw 4% a year, adjusted for 2% inflation. If you don’t like your odds—most investors won’t tolerate anything less than 90% or 95%—then you need to make adjustments. And since you can’t control inflation or investment returns, that means spending less, saving more, or adjusting the amount of risk in your portfolio. “If you do it properly you can ask questions like, if I cut my spending by 5%, or if I shift my equity allocation, what would that do to the probability?” Swedroe explains.

The details matter

There are a number of online Monte Carlo tools, including this retirement nest egg calculator from Vanguard. These are fine for rough guidelines, but beware of planning your financial future on the back of an envelope. As the saying goes: garbage in, garbage out. “We won’t let anyone but a small team in our company run a Monte Carlo because it is too easy to make a minor error that changes everything,” Swedroe warns. The Monte Carlo software used by financial planners can often factor in employer pensions, Canada Pension Plan and Old Age Security, income taxes and other important factors—all of which will have a greater effect on your retirement than your choice of ETFs.