trying to understand impact of risk - not what I thought!

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dlbnew
Posts: 5
Joined: Thu Jul 26, 2018 6:38 am

trying to understand impact of risk - not what I thought!

Post by dlbnew » Sat Jul 28, 2018 5:42 am

This question might be for a different forum such as bogleheads, but I'm trying to understand the impact of risk.

I'm 47 looking to retire at 60. From everything I have read and been told, I should have an allocation of about 60/40 or 65/35 stocks/bonds at this point. However, when I run the simulations, I'm consistently getting a higher success rate and a lower shortfall when I use a "below average risk" portfolio compared to the "moderate risk" all other things held equal. This would mean I need to allocate only 40% to stocks.

This is a surprise. I'm trying to wrap my head around why this is the case.

Do you have some general information on what I should be considering here? Thank you for any information.

One note: at retirement I model the portfolio with 6% return and 3.0% standard deviation in all simulations.

jimr
Posts: 518
Joined: Thu Feb 28, 2008 6:48 pm

Re: trying to understand impact of risk - not what I thought!

Post by jimr » Sat Jul 28, 2018 8:47 am

What you're seeing is a good demonstration of the impact of increasing the amount of uncertainty in a long-range plan. Higher risk means higher potential reward, but also greater uncertainty and a greater chance of a bad outcome.

From a statistics standpoint and the bell curve of the portfolio's expected return, increasing the proportion of stocks moves the bell curve to the right, increasing the portfolio's average expected return. However, the extra risk also widens the bell curve and fattens its tails, potentially considerably. This is what a higher standard deviation means. This fattening means a greater number of potentially bad outcomes. With a lower risk portfolio, maybe 1000 of the 10,000 simulation paths will run out of money before the end of the plan (90% probability of success). However, with a higher risk portfolio, maybe 1500 of the 10,000 paths will fail (85% probability of success).

Note that with a higher risk plan, the median ending portfolio value is likely to be considerably higher, despite the plan's lower probability of success. The higher median ending portfolio comes directly from the expected return bell curve shifting to the right. In other words, on average the portfolio return should be better and thus yield a bigger ending portfolio (at the 50% probability of success level). The problem is what happens at the 90-95% confidence level (90-95% probability of success). Often, the extra uncertainty from the higher risk portfolio overwhelms the higher expected return and increases the chance of a potentially bad outcome by more than enough to offset the benefit of the higher expected return.

As an experiment to help understand this dynamic, you might want to play around with using the custom investing style so you can manually enter the return and standard deviation values. First, try using the higher return from the 'moderate risk' portfolio and combining that with the lower standard deviation from the below average risk portfolio. These nonsensical inputs may help you better understand the relationship between return and risk. When you run the simulation with a higher return but a lower standard deviation, you'll likely see an increase in the probability of success. Next, try increasing the standard deviation in smallish increments and repeatedly running the simulation to see what value of standard deviation results in a probability of success similar to that produced using the below average risk portfolio's average return and standard deviation. You'll probably notice that with a higher return you can have a higher standard deviation, but not that much higher.

This is the fundamental trade off we all have to manage between risk and uncertainty. Compounding the problem is the fact that our estimates of both return and standard deviation are little more than simple guesses. In reality, it's impossible to accurately predict what the risk-reward trade-off will look like in the future. Let me restate that for emphasis. The return and standard deviation values used with the canned portfolios in the Flexible Retirement Planner are just guesses. Nobody knows the correct values to use and this is a big part of the fact-finding/decision-making process that each investor has to research and navigate. The best we can do is use tools like the Flexible Retirement Planner to hopefully shed light on the contours of the risk-reward relationship and help inform our decision-making process.

Welcome to the difficult and uncertain world of predicting the future!

dlbnew
Posts: 5
Joined: Thu Jul 26, 2018 6:38 am

Re: trying to understand impact of risk - not what I thought!

Post by dlbnew » Sat Jul 28, 2018 2:44 pm

Thank you so much for this. This is a wonderful tool I have to say, especially for its educational value.

Your response makes perfect sense. I think I understand the statistics of what is going on here. It's just hard to couple that with mainstream advise. I understand the riskier portfolio bell curve being flatter and having more area in the higher portion of the chart, and having a higher average portfolio mean value. And I guess that is the reason why people advise a riskier portfolio.

But this somewhat seems to be either misleading or not fully aware of what SD is. When you're dealing with the average person's portfolio and retirement plan, isn't the main focus to ensure they have what they need with as much certainty as possible?

I did notice, though, that holding all equal, the same general pattern as shown below holds true for any age, e.g. if I were 27 instead of 47.

I'd like to know the portfolio allocation for those who are VERY good at statistics!

Prob Success (%) Ave Spending Shortfall (%)
Above Ave Risk 93 20
Moderate Risk 96 15
Below Ave Risk 97 12
Risk Adverse 98 10

jimr
Posts: 518
Joined: Thu Feb 28, 2008 6:48 pm

Re: trying to understand impact of risk - not what I thought!

Post by jimr » Sat Jul 28, 2018 7:21 pm

It'd be interesting to see the median ending portfolio value along with the prob of success and spending shortfall for the runs you did above.

Also, keep in mind that a 2-4 point difference in probability of success is basically just noise. You can think of those runs as all having roughly the same probability. The inputs aren't robust enough to justify reading anything into a probability result that's within 5-10% or so of another result. That kind of difference is well within the margin of error of the model, which some suggest is at least 20% or more, given how little we know about what the future will bring.

With that in mind, one could argue that increasing portfolio risk has little impact on probability of success but can dramatically increase the median ending portfolio value if your retirement path ends up normal.

dlbnew
Posts: 5
Joined: Thu Jul 26, 2018 6:38 am

Re: trying to understand impact of risk - not what I thought!

Post by dlbnew » Sun Jul 29, 2018 4:13 am

I've added in the median ending portfolio and bottom 10% values at age 95 to the runs I did below.
With that in mind, one could argue that increasing portfolio risk has little impact on probability of success but can dramatically increase the median ending portfolio value if your retirement path ends up normal.
For my particular situation, I don't have children or siblings who would be in need of an inheritance, really. So median ending portfolio value for me, as I'm sure is the case for many other people, is not important as long as it's not 0.

So leaving hundreds of thousands on the table at the end of life, at the cost of having to work more years, is not an appealing scenario. And it seems the less risky scenario ends with a higher bottom 10% value.

I just can't see why anything more risky than a "Risk Adverse" scenario would benefit someone in my situation. It doesn't seem to get me to my goal of retiring hopefully at age 59, nor make it more likely that my money will last.

Prob Success (%), Ave Spending Shortfall (%), Median ending value ($), Bottom 10% value at age 95 ($)
Above Ave Risk 93,20, 890326, 142185
Moderate Risk 96, 15, 744632, 207391
Below Ave Risk 97, 12, 636096, 233897
Risk Adverse 98, 10, 519293, 224646

Note: For all scenarios, funds are moved to to low risk (6% return, 3% standard deviation) at retirement year 1.

jimr
Posts: 518
Joined: Thu Feb 28, 2008 6:48 pm

Re: trying to understand impact of risk - not what I thought!

Post by jimr » Sun Jul 29, 2018 1:15 pm

Many financial planners follow a rule that says you should only take on as much risk as you need to accomplish your goals.

This might be a case where that rule offers good guidance.

BTW, I would definitely suggest running all this by the folks on the bogleheads.org forum. IMO, that's one of the best sources of online information and guidance available for DIY retirement planning.

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