Inflation affect On SD

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dgator002
Posts: 1
Joined: Fri May 05, 2017 9:53 am

Inflation affect On SD

Post by dgator002 » Fri May 05, 2017 10:12 am

Hello,

What effect does inflation have on the portfolio standard deviation of returns in FRP?

I understand the expected return is inflation adjusted and I assume it uses a formula similar to:
(1+E(R))/(1+E(i))-1

It appears that FRP also adjusts the standard deviation of returns for inflation. I would like to understand how and why this is done.

Thanks,

jimr
Posts: 462
Joined: Thu Feb 28, 2008 6:48 pm

Re: Inflation affect On SD

Post by jimr » Fri May 05, 2017 2:18 pm

The inflation rate doesn't directly interact with the portfolio standard deviation. The inflation rate reduces the portfolio's real average return, but I don't believe it has any effect on the standard deviation.

During each year of each iteration of the simulation, portfolio growth is computed as follows:

1) A pseudo-random portfolio return is generated based on the return-avg and SD parameters specified.
2) The generated return percent is multiplied by the portfolio value to generate a return amount
3) Investment taxes are computed based on the generated portfolio return amount
4) The net portfolio return (after subtracting investment taxes) is added to the portfolio value
5) The portfolio value is then reduced by the inflation rate*

*The portfolio value is maintained through the sim in present value (eg 2017) dollars.

The option to specify an SD along with the inflation rate was sort of an experimental feature that a user asked for at one point. I later learned that there is some research showing that using an inflation SD along with the portfolio SD during the MC sim mostly just adds noise and isn't productive. However, I never disabled the feature.

I recommend that you leave inflation SD at 0.

Jim

Paul O
Posts: 6
Joined: Tue Oct 30, 2018 5:22 pm

Re: Inflation affect On SD

Post by Paul O » Mon Nov 19, 2018 2:38 pm

Jim,

I was looking at the relative sensitivity of using a standard deviation for inflation and the impact of adding noise to the simulation. Does the planner account for negative inflation (deflation) when incorporating inflation variability or is the minimum inflation set to zero?

jimr
Posts: 462
Joined: Thu Feb 28, 2008 6:48 pm

Re: Inflation affect On SD

Post by jimr » Mon Nov 19, 2018 4:55 pm

Yes, if inflation standard deviation is non-zero, the inflation rate can may up being negative and the simulation logic will handle it.

Keep in mind that the simulation varies the inflation rate and portfolio return independently and this may not be an accurate representation of how these variables behave in the real world.

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