In this month’s edition of “Money Matters,” Scott talks about how planning for financial independence has evolved throughout the years and the advantages of using Monte Carlo analysis to more accurately project your financial independence.

Money Matters: Monte Carlo Analysis & Financial Independence Transcript

0:00:00.1 CJ: WTIP is pleased to bring you another addition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He’s taught retirement planning and wealth management strategies to hundreds of financial professionals. And he’s joining us by phone. Welcome, Scott.

0:00:22.8 Scott Oeth: Good morning, CJ.

0:00:23.8 CJ: Good morning to you. So, it was the 4th of July Independence Day earlier this week. And you want to talk to us about financial independence?

0:00:35.4 SO: Yeah. It's one of the most common topics I deal with day in and day out, talking with individual clients and certainly in the teaching is that whole concept of financial independence, and I find more and more. Of course, retirement is a very common goal. A lot of people like the idea of stretching out the hammock and tossing the alarm clock out. But even those who really like working like to know at what point are they financially independent. And in times like today, CJ, where the markets seem to be going crazy and there’s a lot of scary economic news and inflation soaring, there's a lot of benchmark indexes out there and measurements of the market as a whole. But how do we take that back to the individual and know are they on track, the true goal? Are they financially independent? And if so, are they still, after everything that’s going on?

0:01:29.4 SO: So, there’s a lot of different ways of looking at this, some older methodologies, some good ones, some pretty seriously flawed ones. And things have changed happily. We're getting better and better at this. It was only in the mid-’90s, one of the most famous investors in the world at the time, Peter Lynch, he had had an incredible track record, wrote an article saying, "Well, you average about a 10% return over the long haul. You should be able to take about 7% per year out of your portfolio." The problem is, CJ, if you can't swim, you shouldn't listen to someone who says, "Oh, that river’s two feet deep on average, you’ll be fine." It might be 12 feet deep in the middle and...

0:02:12.6 CJ: Exactly.

0:02:12.9 SO: Six inches deep near the banks. And that's one of the problems when, as we're seeing, markets are volatile. So, you can't rely on averages because it makes a big difference. The pattern that the returns come in, money doesn't move in a straight line. And so, some of these older, more simplistic methodologies of answering that question, are we okay, the time value of money calculations, they don’t work real well in real life because of the volatility of markets. And so, one of the techniques that we’re using more and more, it’s commonplace for in our shop and a lot of others is using statistical modeling, what’s called Monte Carlo analysis.

0:02:51.6 SO: And so, it’s using all those same variables, how long someone’s going to work, how long they might live, what their total net worth is, how much income they want, and then using many, many trials to try and mimic the volatility in real life and get more of a range of outcomes rather than a hard number. So, I’ll say this is a complicated area. This might be a bit more mathy than some of the things we talk about. I definitely recommend this would be an area for people if they’re interested in taking a look at this, which I think is a good idea, seek out expert advice from their own certified financial planner or else really be prepared to crack the books, and do some heavy lifting on the math end yourself. It’s a complicated area.

0:03:36.2 CJ: Okay. And you called it the Monte Carlo.

0:03:39.0 SO: Yes.

0:03:39.6 CJ: Simulations?

0:03:41.4 SO: Monte Carlo analysis or Monte Carlo simulations, and the history on it goes back to physicists working on the A-bomb and trying to determine what would happen if it was dropped from different elevations, with different wind speeds, with different temperatures and they’re... So, they came up with this type of statistical modeling. It's used in many, many applications now, many applications even within finance. But the Monte Carlo analysis in personal financial planning, we're looking at these different types of variables and coming up with ranges of possible outcomes and modeling the sequences.

0:04:20.7 SO: And when I was getting going in this business, CJ, an article had just come out in the early ’90s written by a fellow named Lynn Hopewell. And he was an article editor for the Journal of Financial Planning and looked at the field of engineering and said, "Hey, we should be using this to model retirement scenarios, or to answer that big question, are we okay? How are we doing?" But when I was first doing this, we’d have a spreadsheet, and I would get everything set up, and I’d wait until I was leaving the office at night, and I’d hit go because it took hours for the...

0:04:53.3 CJ: Really?

0:04:54.2 SO: The computer to run these thousands of different simulations. Now, in the conference room, I'll have clients in there, we’re up in the big screen, and we can sort of war game different scenarios in real time. What would it look like to retire at age 62 versus 65, or to spend $7,000 a month versus $4,000 a month? And it allows for a lot more testing just because computing power's advanced so much. But what you get out of it is instead of saying something like with a straight-line type calculation, CJ, you could retire at age 65, spend $50,000 a year, and there’ll be $1 million left at age 100.

0:05:35.1 CJ: Oh, I wish.

0:05:35.6 SO: That's for the old-time straight line type determinations. Now, with the Monte Carlos simulation, we might use those same variables, retire at 65, spend $50,000 a year, but what’s going to come out is something more like you have a 70% chance of success based on 1,000 randomly generated trials.

0:05:57.5 CJ: Okay. Wow. Okay. So, it’s kind of a stress test for your financial picture. What can you bear?

0:06:03.1 SO: Yes.

0:06:03.8 CJ: All right.

0:06:05.6 SO: Yes.

0:06:06.1 CJ: So, things have been so incredibly volatile and indexes are closing lower, and people are a little skittish. So, do we have anything to look forward to?

0:06:19.9 SO: Well, it...

0:06:21.6 CJ: In the short term.

0:06:23.9 SO: Yeah, I think...sure. I think when things look glum or things look pretty bad, there's an old saying, Rothschild, who’s a famous investor, said, “The time to buy is when there’s blood in the streets.” And I think what we’re seeing is mounting evidence to these points. I posted an article recently on my blog about consumer confidence readings, so this is a major economic indicator. University of Michigan has a long running standard where they look at consumer confidence, and we're really at rock bottom, CJ. Things look really bad in terms of the consumer confidence intervals, but I encourage you to go take a look at that article because what you’ll find is going back over the last 50 years, when we look at the one-year stock returns going forward from those lows in the market, they're much, much higher. They’re like five times higher than when we see very high confidence readings.

0:07:22.7 SO: So, at some point—and I’m not saying we’re there now, no one knows, we don’t have a crystal ball—we very likely could be heading into recession. Things may be bad for a while, but good companies on sale, you would want to buy when they’re low. So that’s a very interesting one looking at consumer confidence. Another sign of what traders... They like to use the term capitulation, are we at the bottom? Have people kind of given up? Are we finally there? We’re at a very high point for the number of companies that their share price is trading for less than the amount of cash in their checkbooks right now. So, that’s a very interesting one, and some of those companies really are going to have hard times and they’re not...some aren’t going to come back.

0:08:10.7 SO: But we’re looking like something like over 10% of the companies out there, you could buy that company for less than the value of their cash or cash equivalents. That’s a pretty interesting indicator when you look at long-term market history, and I think another big thing for people to keep in mind, because there’s a lot of talk about recession now, alright. And that is something to be concerned about, and definitely encourage you to think through your financial affairs and prepare for what might happen if there's changes in your job situation, albeit the economy and the markets are two different things, okay?

0:08:44.1 SO: In the markets, your investments, your retirement accounts, they tend to lead the economy, both on the way down and on the way up, and investing before a recession, oftentimes, you can't pinpoint these things... I don’t try to, I don’t claim I can or that people should try to do this, but what I'll say is if you look historically, the returns in the year and certainly six months preceding a recession are often quite good because what happens is the market has assimilated all this bad information, things look bad, people sell, people are getting on the market, but then at some point share prices becomes so cheap, they start looking pretty good, so yeah, I think there are... Well, we’re not out of the woods yet. There are some interesting things to be looking at in terms of your long-term money and going forward.

0:09:38.5 CJ: Alright, Well, Scott, we’re just about out of time. Thank you so much for joining us today, and we’ll check in again next month. Anything that you’d like to share before we go?

0:09:51.2 SO: Well, maybe just one quick thing, I heard that you’re in your membership drive, you and I have talked about charitable giving strategies in the past. I think the first thing people think of, and I certainly encourage supporting great organizations like WTIP, is reaching for the credit card or maybe the checkbook. That’s great, but there are some really powerful tax advantage ways to magnify your giving or to stretch your dollars, and so that was back in December of 2020. I know you archive these episodes. I have it on my blog as well, and, of course, always happy... I've had some very fun follow-up conversations with listeners coming off the show. So, encourage you to think about supporting WTIP and do it as smartly and efficiently as possible.

0:10:35.0 CJ: Alright, Scott, thank you so much. We’ll check in next month.