- The Measurement of Risk
- Asset Allocation and Retirement
- Ranging the Possibilities: Monte Carlo Simulations
Asset Allocation and Retirement
Will efficiency do the trick over the long haul? Do modern advancements in the financial world guarantee that the returns to an investment plan or portfolio are going to be high enough to generate sufficient funds to meet future obligations?
In a word: no. That’s why the asset-allocation consultant was created.4 This consultant examines contributions to a plan and expected future outlays and, assuming the past is a good guide to the future, uses historical returns and volatility measures to come up with an optimal investments mix—a mix that most likely satisfies future outlays with a minimal contribution level.
As a person plans for his golden years, he generally has two important things in mind: a picture of the lifestyle he would like to enjoy in retirement and his current net worth. Working backward, the desired lifestyle determines the cash flow required for his golden years. Depending on the expected returns of the various investment classes, one can figure out the target wealth he needs to reach his planned lifestyle. In turn, current wealth level and expected rates of return determine how much an investor must set aside each period so he can meet his long-term objectives.
Conceptually, all this appears fairly simple—but this is the real world. Uncertainty plays a major role in every aspect of life, and investing is no exception. We don’t know what the future holds for our income paths, nor do we know what the income purchasing power will be down the road. We also don’t know what health or family issues can arise in the years ahead, or what extraneous and unforeseen costs will cut into our plans for a second home or year-long vacation abroad. Similarly, we cannot know the actual future paths of the different asset classes that are available for our portfolios. An investor must, therefore, first find out whether the person managing her portfolio has a realistic plan—even before discussing the desirability of alternative asset mixes for a portfolio. She must ask, "Are the long-term objectives you set out for me feasible?"
Pension Plan consultants hoping to answer this question must make a series of assumptions and they can start by assuming mean reversion, or that, ultimately, asset-class returns converge along their long-run historical averages. Consultants know assets tend to return to their means, or averages, after running to their extremes, and with this knowledge, they are able to use the past as a guide to what will likely happen in the future. Advisors can also assume there will be a frequency to the strategy rebalancing of a portfolio and a portfolio will most likely be annually revisited. Armed with these two assumptions, consultants can go back in time, figure out the range of variation in returns for the different asset classes considered for inclusion in a portfolio, and calculate the likely ranges of outcome.