This HowTo2 is a four-page set for financial advisors and investors who want a deeper, fuller view of how to zero in on and judge portfolios that offer best result probabilities for an investor’s dollar plan, future dollar goals, and priorities.
1. Lay out your cash flow plan and goals
2. Define a conservative-to-aggressive range of whole-major-asset-classes-mix portfolios
3. Compare them all in probability of meeting your future dollar goals, on a Goal Frontier graph
4. For the best of those, make further graphic comparisons on:
a. How far above or below the goal the result may be
b. Probabilities for dollar value year by year along the way
c. Examples of ups and downs along the way
5. From these graphic comparisons, select the portfolio you think best for your dollar plan, future dollar goals, and priorities
The rest of this page and the following three in the set provide a richly illustrated explanation of how to do it. This website offers you the tool to do it.
Go through this four-page set twice — at least:
If you don’t yet have Pathfinder — this four-page set is a good preview for seeing how you can use Pathfinder to zero in on best investment choices for future dollar goals.
After you get Pathfinder — going through this page with Pathfinder, producing this page’s illustrated graphs and interactions in Pathfinder, is a great way to become an expert user and beneficiary fast.
To explain it to others — demonstrating this page’s path for pursuit of best investment choices is most effective when presented visually with Pathfinder’s interactive graphs.
Luckily, we’re here today with an investor who has thought out how to pursue an individual investor’s best interests — best prospects for an investor’s future dollar goals. And to do so in ways investors can best understand, for prudent informed decisions.
First, the zero-in graph
For this investor, the first investment-selection basis he wants to see is a comparison of asset-class mixes across the range from conservative, such as all T-bills, out to aggressive such as all stocks. He wants to see these investments assessed and compared in probabilities for meeting his investment purpose, his future dollar goals.
The way to present this investment assessment-and-comparison that he likes is a “Goal Frontier” graph, like this:
(In this HowTo page, each graph is shown with its Toolbox of interactive tools at its upper right. In Pathfinder, those Toolboxes offer tools for interactive uses of the graphs.)
In this graph the dots represent a conservative-to-aggressive range of investment portfolios, from most-conservative all-T-bills portfolio 1 on the left to most-aggressive all-stocks portfolio 11 on the right. And as shown by the labeling for the vertical axis, they all are assessed and compared in probability of meeting this investor’s future dollar goals. Higher is better.
The investor can quickly see that in probability of meeting his purpose, his future dollar goals, according to this analysis portfolio 1 is lowest and worst. Portfolios 4 and 5 are highest and best.
University investment education
won’t get you there
“Whoa!” said a visiting university student, lifting a very heavy textbook. “My investment textbook teaches that investment selection should be based on a different comparison: comparing investment in a pair of numbers the textbook calls ‘expected return’ and ‘risk.’ Sometimes for ‘expected return’ they say just ‘return.’”
“I read and hear and see this university-textbook approach everywhere,” the student added.
“What about an investor’s dollar goals of future years?” the investor asked.
The student answered that “expected return” (or just “return”) and “risk” are not about dollar goals of future years. “They aren’t even about dollars!”
After a pause, the student said that for his own investment, he’d rather use the investor’s graph, comparing investments to reveal the best in probabilities for his future dollar goals.
Then the student asked the big question:
“How do I get from “expected return” and “risk” to your graph,
comparing investments in probabilities for my future dollar goals?”
Following is the investor’s answer.
HOW TO GET THERE
Ingredients for the graphs
1. Lay out projected cash flow plan and goals
Step 1 is to lay out the investor’s cash flow plan and goals, so the analyses and graphs will assess and compare investment portfolios for his dollar plan and goals. Here are the investor’s own plan and goals:
Goals: The investor plans to retire in 20 years, and has set as his investment goals that his investment provide him $20,000 for each of the following 10 years with $600,000 left at the end of those 10 years. (He plans to then purchase a SPIA providing him income for the rest of his life.)
Plan: In hopes of meeting these goals, the investor plans to invest an inherited $300,000 now, plus another $20,000 in each of the next 20 years up to retirement.
Fees, taxes, inflation: The investor plans to put all of his investment in a Roth IRA, so there will be no taxes on his investment. But he estimates that there will be an annual fee of 1% on the value of his investment in the asset class of stocks, and estimates an inflation rate of 2.5%. He has expressed all his figures for future dollars in today’s-value dollars.
If the investor doesn’t have a cash flow plan and goals, he should rough one out anyway. He can refine or change them later. If he doesn’t have them, he doesn’t have a basis for zeroing in on best investments for his future.
2. Select investments to consider
Avoid the oceans of nonsense — There are thousands and thousands of individual stocks and other investments and thousands of mutual funds for which there are numbers offered for measures of their future-return-rate probability labeled “expected return” (or just ”return”) and “risk.” But our investor knows that for almost all of those investments, especially for the long term, those numbers are based on such weak grounds that they are no better than guesses, useless for long-term-investment comparison-and-selection.
Seek firmer grounds –But he also knows that among most-conservative investments such as government T-bills, grounds for those estimates are much better. And across the range of more aggressive investments, whole major asset classes have much better grounds for estimating those future-return-rate probability measures: longer relevant histories, and widest diversification to minimize danger from disastrous performance of any particular business, industry, or investment manager. And mixes of these asset-class investments have even more diversification and are even better.
Lay out a conservative-to-aggressive range of portfolios — Our investor also knows that for longer term investment, investments across the range from conservative to aggressive offer vastly different prospects. More aggressive investments have far higher result possibilities, but also much greater future-result uncertainties.
So a most-important question for him to seek an answer is:
Where, in the range from conservative to aggressive, are the best selections for this investor’s dollar plan and goals?
To pursue an answer, he defines a conservative to-aggressive range of mixes of very conservative T-bills and the far-more-aggressive asset class of all U.S. stocks, like this:
What do these offer for his future dollar goals? How do they compare for his future? Which are best for his future?
Get estimates for “expected return” and “risk” — For the T-bills, and for the asset class of stocks, numbers labeled “expected return” (or just “return”) and “risk” can be easily found on the Web, based solely on these investments’ histories or adjusted to reflect the sources’ predictions. And from these numbers an analyst can easily calculate corresponding numbers for each of the investor’s portfolios. Now, for each of those eleven portfolios he has numbers for those technical measures labeled “expected return” (or just “return”) and “risk.”
Don’t be misled by the labels — But our investor knows something else about those measures and numbers. Those “expected returns” (or just “returns”) are not expected! Those “risks” are not his real risk! His real risk is shortfall for his future dollar goals, and that is not at all what investment textbooks label as “risk.”
While those estimated measures, “expected return” and “risk,” are essential for assessing, comparing, and choosing best portfolios for him, they are not themselves the right measures for the comparison and choice. Those measures and numbers do not reveal or even address what the portfolios offer and how they compare in prospects for an investor’s future dollar goals. They fail to even consider the dollars and years of his plan and goals or the mighty effects of compounding along the way. Those measures, “expected return” (or just “return”) and “risk,” are not what those labels make them seem. They are merely technical measures of probabilities for the portfolios’ percent return rates, for the individual year.
Advance the probabilities
to the investor’s goals
Advance! — What’s required is to advance the probability assessment of each portfolio from percent return rate for the individual year to dollar results for the investor’s particular multi-year plan and goals.
This can be done by applying the single-year percent-return-rate probabilities to the plan’s dollar balance each year through the life of the plan, with effects of compounding along the way. And there’s a way to do it, called Monte Carlo simulation.
“Monte Carlo simulation” sounds fancy. But basically it’s just applying two very logical and understandable ideas:
a. Before choosing a portfolio for your dollar plan and goals, test it on the computer – for your dollar plan and goals.
b. And since the portfolio’s future results are uncertain, like those for a throw of a pair of loaded dice, do what you’d do to assess the probabilities for a pair of loaded dice: test the investment lots of times to see which results are more likely.
With Monte Carlo simulation, the investor can test one portfolio for his multi-year dollar plan to see what it offers in probability of meeting his future dollar goals. Then he can do the same for each of the other portfolios he’s chosen for consideration.
Compare them all
on a single graph
With probability of meeting his future dollar goals assessed for each of his 11 portfolios, through Monte Carlo simulation, all that remains for the investor to complete his answer to the university student is to show and compare the assessments on a single graph – the Goal Frontier graph that sparked the student’s question. Here it is again:
In probability of meeting the investor’s purpose, his future dollar goals, both he and the student can quickly see that according to this analysis, portfolio 1 is worst, and 4 and 5 are best.
To see what each of these portfolios is, beneath the graph the investor could place his table showing the content of each:
From the graph and table together, they can see that in probability of meeting the investor’s future financial goals goals, the portfolio that’s 100% T-bills is worst. Portfolio 4 with 30% stock and 70% T-bills, is the one that appears to be best.