That Let Reality Bite
What happened to stocks during the past three years?
a) They soared in 1998 and 1999 and slumped in 2000.
b) They posted a three-year average annualized gain of 12.3%.
Both are true. The first answer, however, captures our sense of the
market's craziness, while the 12.3% average seems willfully misleading.
Yet, when folks calculate how much money they might have in retirement,
they often ignore the craziness and rely on long-run averages.
That could turn out to be a big mistake. "People don't realize that
averages can be meaningless," says Moshe Milevsky, a finance professor at
York University in Toronto. "It's how you get there that counts."
Even now, most retirement-planning calculators are what experts call
"linear" or "deterministic." They assume folks will earn the same return
year after year. But in truth, the world is a lot messier than that, with
returns coming in an unpredictable mix of dazzling gains and rotten
To capture this uncertainty, Wall Street is turning to "probabilistic"
models, which can help investors gauge their strategy's chances of success.
(Many of these models use so-called Monte Carlo analysis. But despite the
hype about Monte Carlo, you don't always need it to calculate
For instance, T. Rowe
Price Associates' Web site
(www.troweprice.com) offers a retirement-income calculator, while Financial Engines
(www.financialengines.com) and Morningstar's ClearFuture
(www.clearfuture.com) can help those saving for retirement. These models won't offer a
simple thumbs up or down on your strategy. Instead, they focus on how
likely you are to meet your goals.
Intrigued? Here is why you might want to try playing with these new
Deterministic models give investors a false
sense of security, argues Scott Trease, a financial planner with Ronald
Blue & Co. in Charlotte, N.C.
"When I do linear analysis using average returns, I get a single number
for ending wealth," Mr. Trease says. "But when I run a Monte Carlo
simulation, I might find that I only achieve that ending wealth 45% of the
Probabilistic models can help you fine-tune your retirement
saving-and-spending strategy, so that you have a greater chance of success.
But don't expect to eliminate all risk. For your strategy to have a 100%
chance of success, you may have to save extraordinary amounts or spend
"As a rule of thumb, I like a 90% success rate," Mr. Milevsky says.
Beyond that, "it takes a lot of effort to reduce risk further."
Deterministic models not only overstate your
chances of success, but also don't show how badly you could
According to Chicago's Ibbotson Associates, stocks have gained 11% a
year during the past 75 years. But even if you enjoy average returns that
approach that level, you may end up with far less wealth than a
deterministic model suggests.
As you discover when using a probabilistic model, it is entirely
possible that long-run returns could be one or two percentage points lower,
which would make a big difference to how much wealth you accumulate. More
critically, even if you clocked 11% a year, a lot depends on when those
gains are earned.
If you are saving for retirement, you would rather have lousy
performance now and great returns later, when you have more money at stake.
Conversely, if you have just retired, you want great returns now, before
your portfolio is depleted by your own spending.
"The sequence of returns is critical when it comes to spending in
retirement," says John Rekenthaler, president of online advice for
Chicago's Morningstar Inc. "If you get bad returns early in retirement, you
can quickly end up with just 75% of your starting assets."
If you plug your current wealth, monthly
savings, time horizon and expected return into a deterministic model, you
will be told exactly how much you will amass. Not enough money? The
temptation is to gun for higher returns, by plunking more into
But there are two problems with that. First, you may not be able to
stomach the extra risk. Second, that extra risk may go unrewarded, notes
Alexander Zaharoff, a managing director with J.P. Morgan Chase & Co.'s
private bank in New York.
"In a deterministic model, taking more risk by putting more in stocks
will always give you a better outcome," he says. "But with a probabilistic
approach, taking more risk by taking on more stocks may reduce the chances
of staying solvent. It may raise the upside, but also increase the
probability of running out of money."
To understand this trade-off, consider a rule of thumb offered by
William Bernstein, an investment adviser in North Bend, Ore. Mr. Bernstein
notes that stocks have a higher expected return than bonds.
But there is a cost. He figures that, over the long haul, bonds could
potentially fall one percentage point below their expected return, while
stocks might fall three percentage points below. The bottom line: Adding
more stocks may boost your portfolio's likely performance. But because
there is more uncertainty about stock returns, there is also a greater
chance of earning far less than you expected.
Write to Jonathan Clements at