In developing a financial plan, the advisor commonly uses the phrase “probability of success” in their report to describe the probability to achieve your retirement and life’s goals. What does the “probability of success” actually mean? If you have 100% probability of success, should you throw a party to celebrate? What about a 10% probability; is it the end of the world and time to panic? What about 50% probability? Is “probability of success” really the best way to look at the results?
To begin exploring these questions, let’s first address what is meant by the reported “probability of success.” The probability percentage is found by computer analysis of 1,000 randomly-generated scenarios considering returns on the inputted assets and liabilities in your portfolio, which is referred to as a Monte Carlo simulation. The randomly-generated scenarios are bound by the statistical return rates and volatility associated with each of the asset classes in your portfolio. The statistical data utilized in the analysis relies heavily on historical numbers but may also be adjusted for anticipated future performance.
For an example of how the Monte Carlo simulation works, let’s assume you invest in a US large-cap fund with a historical/predicted mean annual return of 10% and a volatility 
of 16%. Volatility is typically measured by the standard deviation, which represents the degree of deviation from the mean. As shown in the figure, standard deviation characterizes a range, from the mean, in which the actual realized return will fall 68% of the time. 95% of the time, the realized return will be within 2 standard deviations of the mean. The 1,000 Monte Carlo simulations of the large-cap fund will utilize these constraints to randomly generate returns for each year such that roughly 680 simulations will have a return between -6% and 26% (10% mean +/- 16% standard deviation), and around 950 simulations will have a return for the year between -22% and 42% (10% +/- 32%). The remaining 50 simulations will fall in the extremes below -22% or above 42%. All simulations should result in an overall average annual return of 10%, but the analysis examines what might happen if there are several years in a row with better-than average (or exceptional returns), while others might begin with several years of negative returns.
Now, let’s say the Monte Carlo simulation in your financial plan produces a 99% probability of success. This outcome means that 10 out of the 1,000 random scenarios produced a result where your net worth dropped below $0 sometime during your lifetime (or your estate value was less than desired). An alternative way to look at the results is that 990 scenarios (out of 1,000) resulted in a positive outcome.
These Monte Carlo analyses are performed with two key considerations:
- The financial planning effort is an attempt to predict the future. As such, there are a number of assumptions, or educated guesses, that are required to complete the analysis. These assumptions may or may not prove to be correct. As a matter of fact, depending on the stage of life, these assumptions will likely evolve or change from time to time (i.e. marriage, divorce, promotion, demotion, kids’ educations, large purchasing etc.)
- The simulation assumes that all parameters such as expenses and savings rates/methods remain constant or change only as specifically identified in the input. In other words, the simulation is really an-input oriented (controlled) analysis and input adjustment may be needed throughout the investment/financial planning period.
Prediction of the future is a difficult business and plan adjustments may be necessary in the future to accommodate assumptions that do not turn out to be accurate. Additionally, life is rarely, if ever, unchanging. Therefore, Personal Prosperity prefers to look at the Monte Carlo simulation results as the “Probability of Adjustment.” A reported 99% “probability of success” is actually better considered as a 1% “probability of adjustment.” In other words, to achieve success in the financial plan, you have a 1% chance of needing to make adjustments somewhere along the way. Your plan may not actually “fail” if you can plan for and make future changes to your financial situation. Looking at your financial plan as an adaptable blueprint seems like a much better perspective than approaching the situation as a pass/fail affair, correct?
Now that the dry technical discussion is out of the way, let’s revisit the initial questions, but utilize the “Probability of Adjustment” standpoint. Let’s say the financial planning effort results in a 50% probability of adjustment. Financial planners will likely advise you to incorporate immediate adjustments into your plan to lower this probability of needing future adjustment (or raise the probability of success) as we like to be on the conservative side of planning for your financial future. The reality of the analysis is that you actually have a 50/50 chance of living the life you want without having to make any future changes. If you have flexibility to reduce future expenditures (or to make other adjustments to the plan) when needed, you can effectively raise your probability of success by incorporating future adjustments, when necessary, into the developed financial plan. A key consideration of this strategy is to also consider the magnitude of change that might be needed for future adjustments. For example, if the proposed future adjustment is an expense reduction that would cause significant hardship, then planning for this adjustment is likely not advisable.
If your financial planner were to tell you that your analysis resulted in a 0% probability of adjustment (100% probability of success), is that outcome worth celebrating? The answer: it depends on your goals and lifestyle. A 0% probability of adjustment might mean that you are actually saving too much. Are you best utilizing your wealth and hard-earned dollars to support the life you want to live? Maybe you should spend more, buy something you’ve dreamed of for a long time or make a donation to charity. On the other hand, maybe you are young and in the beginning phase of life. Maybe you would like to have a good amount of cushion to accommodate and plan for those future life changes. Bottom line, you should think about the analysis results considering the stage of life you are in and determine what actions might be appropriate.
How about the other extreme? A 90% probability of adjustment (10% probability of success) indicates that only 100 out of the 1,000 random scenarios produced a positive outcome using the assumptions and roadmap entered into the analysis. If you lead a charmed and lucky life, you may still successfully live the life you desire without making any changes. However, when dealing with one’s financial security, these odds are likely not adequate. Therefore, your financial planner will typically recommend you make some immediate adjustments to reduce your future probability of adjustment.
Bottom line, the Monte Carlo analyses utilized in modern financial planning is a very powerful tool to assist in the decision-making process. The methodology is highly dependent upon the input parameters and assumptions underlying the analysis and it is predicated on strictly adhering to the modeled plan without adjustment. Real life is full of twists and turns; things don’t always turn out as expected and we may choose to change course during our individual journeys. Therefore, results of the financial planning analysis are better served by looking at it as a probability of needing to make a future adjustment. The financial plan should be tailored for each individual to best fit their goals and personality. The plan should then, as a minimum, be reviewed on an annual basis to track the direction of the Probability of Adjustment and to identify when a course adjustment may be warranted.