HowTo2b

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HOW TO USE THE GOAL FRONTIER

F.
Use interactive graphics
for wider, fuller understanding

This kind of graph is not everyone’s cup of tea. But to help almost everyone understand this graph and see its value, for any portfolio a horizontal line can be draw from that portfolio’s dot straight across to the vertical axis on the left to show that portfolio’s goals-meeting probability. The Pathfinder software has an interactive tool to display that on the graph for any of the portfolios, like this:

vGraphTread4

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G.
Caution!
It’s built on assumptions!
Test them!

The Monte Carlo process is just lots of calculation — nothing to criticize there. But principal numbers on which the calculations are based are estimates for an unknown future.

So this whole assessment-and-comparison should certainly not be viewed as “precisely right.”

One questionable basis for it is those numbers for the portfolios’ so-called “expected return” and “risk” — the same numbers used as the textbooks’ measures of investment comparison-and-selection. Even for whole major diversified asset classes, those numbers are based on inadequate grounds for precision and may well be off by whole percentages. It’s prudent to lower those estimates for “expected return” by 1%, or even 2%, to see if portfolios 4 and 5 still appear to be best.

The investor did just that. He lowered the “expected return” estimates for T-bills and for All-stocks each by 1% and had his computer carry out all the simulations again and display the Goal Frontier graph with all the portfolio dots reflecting those lower numbers. It looks like this:

vGraphTdown1read8

This graph shows that with the “expected returns” lowered by 1%, portfolio 4 drops from the previous goals-meeting probability of 87% down to about 64% –its risk of falling short is nearly tripled, from 13% to about 36%. That’s one chance in three of failure to meet the goals. On this graph, for best goals-meeting probability the investor would have to move to the more-aggressive portfolio 8, which offers a not-very-high 78%. That’s almost one chance in four of failure to meet the goals.

The investor thinks the downward adjustment of the “expected returns” may be reasonable estimates for what may be ahead , and thinks the resulting probabilities are too low — not satisfactory for his invest-for-retirement plan.

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H.
Assess feasibility of the plan-and-goals

This graph illustrates another major use and value of the Goal Frontier: testing feasibility of the plan-and-goals. If none of the portfolios offer offer a goal-meeting probability the investor considers satisfactory, his dollar plan and goals may not be feasible. Maybe to raise his goals-meeting probabilities, he should increase his annual investments, or lower his retirement goals, or delay retirement for a year or more.

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I.
Test changes
Assess them on the Goal Frontier

The investor thinks the downward adjustment of the “expected returns” may be reasonable estimates for what may be ahead , and thinks the resulting probabilities are too low — not satisfactory for his retirement plan. So he decides to change something. But before squeezing his current budget to increase his annual investments, or planning to delay retirement, he decides to change something else:

Add or change asset classes in the model portfolios

In the current analysis, the investor has only two components in his portfolios: T-bills and all-stocks. Two is the minimum number for defining a series of mixes across the conservative-to-aggressive range. He decides to add a third asset class less conservative than T-bills but more conservative than stocks: the asset class of US bonds, often called “fixed income.”

He redefines his model portfolios, keeping all-T-bills at the conservative end and all-stocks at the aggressive end but working the US Fixed-income asset class into all the portfolios in between, in such a way that in the middle of the range Fixed income is almost equal to each of the other two in percentage allocation. In the Pathfinder window for defining model portfolios, his revised portfolios’ allocations look like this:

ModPortsF

For these revised portfollios, the Goal Frontier graph looks like this:

vGraphTFread5

This the investor likes! With portfolio 6, the analysis shows his goals-meeting probability at a high 95%. And portfolio 5 is shown almost as good.

But that’s with the original estimates for the asset classes’ “expected returns.” Will this set of three-asset-classes model portfolios offer satisfactory probabilities with their “expected return” estimates lowered by 1%? The investor lowers those “expected return” estimates and has his computer redo the analyses. The Goal Frontier of those results looks like this:

vGraphTfdown1read6

Even with the added asset class, the 1% lowering of “expected returns” lowers the portfolio dots so much that the highest offers goals-meeting probability of only 78%. “That’s one chance in seven of insufficient money when I’m old,” the investor thinks” Still not good enough.

Adjust the cash flow plan, or goals, or both

Reluctantly, the investor decides to squeeze another $600 out of his monthly budget for additional investment, every month for his next 20 working years, raising his annual additions to his investment from $20,000 to $27,200.

With this change, the Goal-meeting probabilities of the highest portfolios look terrific to him.  Portfolios 3 and 4 each offer 98%:

vGraphTF06read4

With the two changes now in his plan — including the Fixed income asset class in his portfolios, and increasing his annual investment up to $27,200 — even with the “expected return” estimates down 1%, his Goal Frontier graph shows good probabilities, with portfolio 6 offering goals-meeting probability of 90%. The Goal Frontier looks like this:

vGraphTfdown106read6

“That’s it!” he concludes. “Include Fixed income in the portfolios, and raise my annual additions to my investment up to $27,200. With these changes I’ll be much more confident of adequate finances through my retirement years.”

It’s your life!

An observer might comment that he liked it better with just one plan and one Goal Frontier. Several of them makes what to do more uncertain.

“I couldn’t disagree more!” this investor would reply. “It’s the future that is uncertain. These Goal Frontiers are showing us what the future uncertainties mean for our financial futures.

“As I’ve said, this investing will shape the second half of my future! I want to take some time to see and test alternatives for that.”

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