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The foundation of every financial plan involves projecting income, expenses, assets, and liabilities into the future and making recommendations to optimize the client’s desired outcomes. Even though we coach clients to weather volatility from year to year to help them achieve the long-term returns they’re hoping for, there’s a big difference between the impact of volatility on their financial plan when they’re in the accumulation stage of their life versus the decumulation stage.
If a few more years of poor to low returns are added – compounded with the fact clients need to take out more every year to offset inflation and that people are living a lot longer than they used to – the next time that financial plan gets updated, it could be telling a story of ruin versus success. Back testing is a method in which one runs the financial plan assumptions against various historical performance patterns of the portfolio to see how often the plan would have been successful given the target portfolio.
But of all the methods mentioned, Monte Carlo Analysis is probably the industry gold standard. This analysis exposes the financial plan to 500-1,000 randomly generated sequence of returns, based on the return and risk assumptions of the underlying portfolio, and produces a probability of success score.