By Peter T. Waldron
Managing Partner of Waldron Partners
“The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is fear of the unknown.” H.P. Lovecraft
My oldest daughter was having a hard time sleeping one night and I asked her what was troubling her. She said that she feared our house was going to burn down. My response to her was that FEAR is false evidence appearing as reality, she said, “What do you mean?”
I continued (mind you this is a logical thinking child) by finding out how many home fires occur every year locally and nationally. I explained using the statistics that the probability of our home burning down was less than .27%. This did not seem to satisfy her. So, I continued by asking her, “how many homes have you seen burned down?” Her response was “none.” From there I explained that the number of home fires that occur compared to the total number of homes is such a small amount, and that the fear of our home burning down is not realistic. I continued to explain that while there are things to fear in life, this is one that we can plan for by making sure to turn off the stove, put hot coals out, and make sure that rodents are not chewing the wires in the attic.
Like home fires, a lot of people fear the big correction in the stock market, mostly this fear is emotionally driven and does not include any facts. The average recession in the economy is one and a half years (the longest was the Great Depression at three years and seven months). Conversely, if you look at the S&P 500 since 1927, the longest it has had negative monthly returns was nine months (1974) and the longest it had negative annual return was three years (1939-1941). With this information you could argue that it may be a wise choice to just buy the S&P 500, however another data point would be that of the ninety-two years that I looked at, the S&P was down twenty-nine years and up sixty-three years. So, how do you plan your investments? While you can’t control market volatility, you can build plans designed to minimize volatilities’ impact on your goals.
How? This is done through building an economic model of one or a hundred different life goals and then tying those goals back to an investment strategy. Then, testing that strategy using an economic tool called Monte Carlo analysis. Monte Carlo analysis is a financial forecasting method which uses simulations to project and illustrate the probability of a certain outcome. Monte Carlo is (not a casino) a tool that tests 1,000 random outcomes that might happen in your portfolio given your allocation and your future goals. This approach allows you to better understand whether your goals are realistic or if your portfolio is too conservative or aggressive given your goals. Using data to make decisions helps eliminate the emotions that fog your judgement and hold you captive while your life slips out from underneath you. Your future is yours to plan, and while planning isn’t a certainty, it is much better than living in uncertainty whether your home is going to burn down, or your portfolio is going to fail you when you need it most.
A Monte Carlo simulation illustrates how your future finances might look based on the assumptions you provide. Though a projection might show a very high probability that you may reach your financial goals, it can't guarantee that outcome. However, a Monte Carlo simulation can illustrate how changes to your plan could affect your odds of achieving your goals. Combined with periodic progress reviews and plan updates, Monte Carlo forecasts could help you make better-informed investment decisions.
Important: The projections or other information generated by Monte Carlo analysis tools regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary with each use and over time. Because of the many variables involved, an investor should not rely on forecasts without realizing their limitations.
“By failing to prepare, you are preparing to fail.” ? Benjamin Franklin
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Peter T. Waldron is a registered representative of Lincoln Financial Advisors, a broker/dealer, member SIPC, and offers investment advisory service through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor, Waldrons Partners, 3201 Danville Blvd., Suite 190 PO Box 528 Alamo, Ca 94507. Waldron Partners is not an affiliate of Lincoln Financial Advisors. Insurance offered through Lincoln Marketing and Insurance Agency, LLC and Lincoln Associates Insurance Agency, Inc. and other fine companies. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstance. The content of this material was provided to you by Lincoln Financial Advisors Corp. for its representatives and their clients. CRN2919952-012320