I am new to FRP so please forgive if the answer to my question is common knowledge.
The standard deviations associated with the selectable investing styles appear to vary significantly from historical market returns for DJIA, SP500, etc (e.g. moderate risk' stdDev is 7.1 and DJIA over past 38 years is approx 15). I am interested in building a custom investing style that implements incrementally more moderate risk over the coming years, so I need to enter apprppriate standard deviations.
Can someone help me understand how the FRP default standard deviations were derived, why they appear to be different from other references I find and ultimately, what values are appropriate for 60/40, 50/50, 40/60 and 30/70 asset allocations?
Investing Style
Re: Investing Style
Hello,
Your question is a good one and gets right to the heart of one of the biggest challenges in using this type of tool. No one really knows what the future will bring in terms of the return/standard deviation that we're likely to experience over the next 2030 years.
The values associated with the investing styles are just best guesses that are based on historical return for a broadly diversified portfolio. The reason the standard deviation for the moderate portfolio is lower than the standard deviation for the DJIA is because the moderate portfolio assumes a mix of stocks and bonds, which tends to dampen volatility.
I do encourage you to explore different rates of return and standard deviations and especially to explore the 'sensitivity analysis' feature, where you can better visualize the impact of changes in these inputs. In particular, try entering all your plan information into the planner then going to sensitivity analysis and choosing return for parameter 1 and standard deviation for parameter 2. This tools makes it really easy to see that a higher average return isn't always better when it also comes with higher volatility.
Hope that helps...
Jim
Your question is a good one and gets right to the heart of one of the biggest challenges in using this type of tool. No one really knows what the future will bring in terms of the return/standard deviation that we're likely to experience over the next 2030 years.
The values associated with the investing styles are just best guesses that are based on historical return for a broadly diversified portfolio. The reason the standard deviation for the moderate portfolio is lower than the standard deviation for the DJIA is because the moderate portfolio assumes a mix of stocks and bonds, which tends to dampen volatility.
I do encourage you to explore different rates of return and standard deviations and especially to explore the 'sensitivity analysis' feature, where you can better visualize the impact of changes in these inputs. In particular, try entering all your plan information into the planner then going to sensitivity analysis and choosing return for parameter 1 and standard deviation for parameter 2. This tools makes it really easy to see that a higher average return isn't always better when it also comes with higher volatility.
Hope that helps...
Jim
Re: Investing Style
Thank you Jim, this is very helpful.
I'd like to use the Sensativity Analysis tool. Do you have any suggestions on where I might find reference material that contains tabulated date of historical returns & stdDev for various 'classical' asset allocations?
BTW your tool is excellent and I am very appreciative!
I'd like to use the Sensativity Analysis tool. Do you have any suggestions on where I might find reference material that contains tabulated date of historical returns & stdDev for various 'classical' asset allocations?
BTW your tool is excellent and I am very appreciative!
Re: Investing Style
The links below are somewhat random (from google), but they show some model portfolios along with historical return and standard deviations.
http://www.ifa.com/portfolios/
http://www.aaii.com/assetallocation
One thing to be aware of is that rate of return is tightly coupled with the inflation rate that you use. Reducing the inflation rate has the effect of increasing the real return without you actually changing the return/std dev. values. To maintain the integrity of the numbers, when you adjust the inflation rate it's probably best to also adjust investment return by a similar amount. (eg. if you set inflation to 2% instead of 3%, you might want to drop your rate of return by 1%).
Jim
http://www.ifa.com/portfolios/
http://www.aaii.com/assetallocation
One thing to be aware of is that rate of return is tightly coupled with the inflation rate that you use. Reducing the inflation rate has the effect of increasing the real return without you actually changing the return/std dev. values. To maintain the integrity of the numbers, when you adjust the inflation rate it's probably best to also adjust investment return by a similar amount. (eg. if you set inflation to 2% instead of 3%, you might want to drop your rate of return by 1%).
Jim
Re: Investing Style
very helpfull, thank you!

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 Joined: Sat Nov 30, 2013 8:16 am
Re: Investing Style
When min=90 and max=150, I get 100% I get a probability of success of 100% and a green light. when I set min=75 and max=150 I get probabilty of success 100% but a yellow light and an average shortfall of 0%. Because I lowered the minimum funding rate that can be used, shouldn't I get a green light?
Re: Investing Style
It sounds like you're talking about using the flexible spending policy and adjusting the spending policy floor and ceiling percentages in the settings window.Username1na2 wrote:When min=90 and max=150, I get 100% I get a probability of success of 100% and a green light. when I set min=75 and max=150 I get probabilty of success 100% but a yellow light and an average shortfall of 0%. Because I lowered the minimum funding rate that can be used, shouldn't I get a green light?
In order to get a green light, the simulation must end with a positive portfolio balance over 90% of the time, and it must (more often than not) give the retiree 90% of their requested annual spending amount over the life of the plan.
I can understand how this can be confusing, since the simulation is doing what you told it to do. But it seemed incorrect to give a green light to a result where only 75% of desired retirement spending is provided.
Jim
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