“He who lives by the crystal ball soon learns to eat ground glass.”
–Edgar R. Fiedler
Financial planners are asked to be, among other things, soothsayers, and determine what the future holds for their clients. Since we have not yet invented time travel to go into the future to be able to accurately report on what will happen, we must use forms of prognostication to try to predict what will happen and how our clients’ plans will prepare them for that future.
There are many tools used in making those projections. Most people use simple averages. The stock market averaged a total return (capital appreciation plus dividends) of 9.4% from 1900 through 2011, and inflation was 3%, so planners expect a real return of 6.4% and use that as an average real return going forward. The problem with such simplistic calculations is that the market fluctuates, often wildly. Rarely does it yield 6.4% real return, and it certainly won’t do that every year for the next 30 years.
Others, who realize the shortcomings of the simple average method like to use what is called aftcasting. Aftcasting means acting as if you were dropped at some time period in history and lived for the next X number of years, and at the end, if you still have money, then you succeeded. They look at time periods, usually from 75-90 years back, run each year as if you were plopped down there, and if you succeed a given percentage of the time – usually 80% – 90% – then they declare your plan a success and move on.
While aftcasting is better than simple averaging, I do not believe it to be better than accurately derived Monte Carlo projections. Monte Carlo projections take a random number in a provided range and use that number for a given return. So, let’s say that I want to project 5 years of real returns. The first year might be -1.5%, the second year +4.6%, the third year +3.3%, and so on. I then repeat that exercise repeatedly to generate an average and an expectation of what best and worst cases could be.