How to Use Living Standard Monte Carlo

Investment returns vary from year to year, and although the return does have a long-term average, account balances rise and fall as the market changes from year to year. MaxiFi’s Living Standard Monte Carlo risk analysis will help you understand how this annual variation impacts your annual living standard and discretionary spending. The Living Standard Monte Carlo helps you to see if you are taking too much risk, more risk than you need to, or perhaps too little risk with your investments as you explore different investment strategies and spending behavior settings.

How to Get Started

To begin, after opening the application and entering your data, navigate to Dashboard and Reports and choose to run the Risk Analysis report. The easiest way to begin is to just select preset investment strategies for your Base Strategy (MaxiFi automatically sets up two default approaches—"Safe" and "Risky"—to compare with your Base). Using this quick start approach, you choose from among our group of common investment strategies—for example, "Always Conservative" or "Always Moderate"—and use the drop down selectors to assign an investment strategy for each of three pools of money:

  1. Regular Assets
  2. Retirement Assets (spouse/partner)
  3. Retirement Assets (spouse/partner).

This approach is a quick way to get started, and once you see a report you can come back and fine tune things later. Once you have selected your investment strategies, you are ready to proceed to the next screen and set spending behavior.

Creating Custom Assets and Investment Strategies

If you want to build custom assets and investment strategies, use the "manage assets" and "manage investment strategies" links on the Risk Analysis setup screen. An asset is anything with a return history such as a mutual fund or stock or bond position. An investment strategy is an asset or group of assets assigned to one of the three groups of assets listed above. An investment strategy can be built to remain constant or change over time.

The easiest way to create a custom investment strategy is to start by customizing an existing strategy and adjust percentages, ages, and assets in the strategy rather than starting from scratch. To create a custom asset, you will need at least 10 years of return history on your asset. Help instructions in this area will guide you in creating your custom assets and strategies.

Setting up Spending Behavior

This next screen asks you to set up your spending behavior. This setting is important because how you spend each year relative to the actual returns you get in the market (for better or for worse) can have an important impact on your planning model. Conservative spending (spending in a way that assumes your rate of return is less than expected) can provide a hedge against the risk of an aggressive asset allocation. Appropriate spending behavior (for example, spending as if your rate of return is lower than the historical average) is just as important as appropriate asset allocation, a principle that conventional Monte Carlo simulation risk analysis ignores.

The settings on the spending behavior page ask you to indicate for each strategy—base, safe, and risky (default labels you can edit)—what you want to describe as a "safe rate of return." In other words, even though you may be aware that historically your average rate of return is 7%, you may want to assume that you will spend as if you are only earning an average 5% return. This approach would be an example of building a model that "underspends" your anticipated return. You could also do the opposite and model aggressive spending. Your assumptions about safe rate of return do not need to mirror your investment strategy. Indeed, it has been said: "if you invest aggressively, you should spend conservatively; if you invest conservatively, you can spend aggressively." Trying different combinations of investment strategies and spending behaviors is a way to learn about their importance to your particular planning model. It is reasonable to assume the same spending behavior for each of the three investment strategies as a place to begin and establish a benchmark for comparison.

The two distribution charts seen here illustrate the same investment strategy but with different assumptions about spending behavior. The one that tips upward reflects a conservative spending behavior and the one that tips downward reflects an aggressive spending behavior.

Understanding Monte Carlo Reports

The first screen after the slideshow introduction—the Per-Adult Living Standard Comparison—shows an overview of each of the three investment strategies. These horizontal bars represent all the living standards produced and display them relative to their distribution around the middle or median per-adult living standard. The middle 50%, for example, are represented as the dark blue band. You can think of these bars as showing you how tightly clustered or dispersed your living standard will be, taking the hundreds of scenarios as a whole, around the middle (the orange line). The extremes of the far left and the far right represent outside statistical possibilities given your spending behavior and asset allocation.

Risk has several dimensions as we see in these charts shown. One kind of risk is having a lower average living standard through life. Another kind of risk involves having that living standard distributed widely either side of the middle. By offsetting one kind of risk you often invite another. In these charts, the lower median living standard enjoys a more tightly clustered set of possible living standards either side of the middle. In other words, the disadvantage of a lower average living standard is offset by having most of the possible living standards clustered closely around that middle which suggests a more predictable living standard (less variation) from year to year.

The Range and Standard Deviation

Each report provides up to three alternate sets of charts that provide some perspective on the risk entailed in the investment strategy and spending behavior. The first, as discussed above, shows the plans not across time but rather "all at once," allowing you to see at a glance the middle and the deviation from the middle in the models as a whole.

Living Standard Distribution

The next chart presents all of the trajectories produced in the simulation across time allowing you to view the range or distribution of possibilities in any single year. In other words, any single year across the chart can be viewed as a vertical slice of the distribution of possible living standards in that year. As time progresses moving left to right on the chart, the range of possible living standards in any given year tends to get wider as the distribution of possibilities from low to high fans out. The shaded regions show how tightly clustered the possible living standards are around the median. Those within 50% and 80% of the median are the ones you are most likely to experience and thus should be most concerned about. Those on the outside edge of the cone (the outside 5%) represent statistically lower possibilities. This chart tips upward on the right because the spending behavior (see above) is conservative. The model underspends each year pushing unspent wealth each year into the future causing the chart to tip upward to the right.

Living Standard Trajectories

The third chart shows five of the hundreds of living standard trajectories from very low to very high. While most trajectories will locate around the middle (see the chart above), ending up on a higher or lower trajectory with lots of ups and downs over the years is a possibility you should not ignore. Each line represents a possible annual living standard path for one of hundreds of lives lived. Each trajectory represents a higher or lower average spending than another trajectory. Each trajectory has a lifetime average and the chart displays five of these trajectories according to their relative lifetime average in the group (5th percentile means that among the hundreds of trajectories, 95% did better).

Next Steps

Assessing the risk in your financial model is a matter of balancing risk and reward. One thing you learn from this unique analysis is that your asset allocation (the ratio of stocks to bonds for example) is important but not the end of the story. There's no reason to assume that you will blindly spend the same amount year after year regardless of how well or poorly your investments preform. You can adjust your safe spending levels to reflect the reality that you can underspend expectations based on historical averages and tilt your living standard upward through time. You can also model aggressive spending and observe the living standard downside of rigidly spending (or even overspending) your long-term historical average even when your investments are performing poorly.

When you get a feel for the way these variables work, you can use what you learn about investment strategies and spending behavior to set a safe rate of return in MaxiFI's for each of the three pools of money we described above and create a long-term planning model that reflects your tolerance for risk to your annual living standard. And of course you also want to visit your brokerage account or investment advisor and rebalance your regular and retirement assets to align with the conservative or aggressive investment strategies that make the most sense in your MaxiFi planning model.