In the Face of Uncertainty:
Probability-Based Analysis
Mike Dechiario, CFP®
Senior Vice President, Wealth Advisor
Morgan Stanley Smith Barney
Two Logan Square, 13th Floor
Philadelphia, PA 19103
(215) 963-3866
Investments and Services Are Offered Through Morgan Stanley Smith Barney LLC. Member SIPC
CRC# 432549
First use: 5/2012
Expiration: 5/2013
Agenda
•
What are the limitations of traditional financial analysis in the Face of
Uncertainty?
•
How does Probability-based analysis handle uncertainty?
•
What does a Probability-based analysis report look like?
•
What level of service can you expect from us?
•
What is your vision for managing your wealth?
•
Who are your trusted advisors?
•
What is the typical timeline for becoming a client?
Seminar created by Michael Dechiario, CFP®
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Table of Contents
Page
I.
Limitation of the Traditional Financial Analysis Method
– Life is Complicated
– The Dream World
– A Possible Asset Allocation
– A Hypothetical Investment Scenario
– Timing Matters
– Traditional Investment Expectations
– The Real World
– The Dream versus the Real World
II. Probability-Based Analysis
– Probability-Based Analysis
– Probability-Based Analysis Helps Answer
Important Questions
– The Probability-Based Process
– Monte Carlo Simulations
5
6
7
8
9
10
11
12
13
14
15
16
17
18
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Table of Contents
Page
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Comparing Traditional and Probability-Based Analysis
Example of a Probability-Based Financial Analysis
Assumptions
Other Important Information
Ideal Goals – Probability 30%
Acceptable Goals – Probability 95%
Recommended Goals – Probability 85%
Risk Tolerance through Probability-Based Analysis
Risk Tolerance Chart – Percentages
Risk Tolerance Charts – Based on $10 million
Selected Outcomes of Probability Process
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20
21
22
23
24
25
26
27
28
29
–
–
Conclusions
Important Disclosures
30
31
4
Limitation of the Traditional
Financial Analysis Method
5
Life is Complicated
Investors have multiple spending objectives
Individuals
– College Tuition
– Business Start-Up
– Retirement
Institutions
– Grants and Endowments
– Actuarial Liabilities
– Administrative Expenses
• Goals may be pursued over different time horizons
• Portfolio contributions may vary over time
•
•
•
Gifts and Bequests
Bonuses
Deferred Compensation
•
•
Rollovers
Structured Settlements
Interaction of market volatility and cash flow timing has a powerful effect on potential portfolio growth and ultimately on the
achievement of meeting these important objectives
6
The Dream World
Growth of $100,000 assuming an Average Annual Return of 5%
The Dream World
$155,132
$160,000
$147,745
$140,710
$140,000
$134,009
$127,628
$121,550
$115,762
$120,000
$110,250
$105,000
$100,000
$100,000
$80,000
$60,000
$40,000
$20,000
$0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
For illustrative purposes only. Actual returns would vary. This is a hypothetical portfolio that does not represent any specific investment
and does not include the effects of any taxes, fees, or charges that may be imposed with the actual investment.
7
A Possible Asset Allocation Model
A Dream W orld Possible Asset Allocation
5%
30%
65%
Cash
Bonds
Stocks
This model is shown for illustrative purposes only. It does not represent individually tailored investment advice.
Actual portfolio allocations will vary based on individual circumstances.
The asset allocation illustrated is not necessarily suitable for all investors.
8
A Hypothetical Investment Scenario
Assumes an average annual return of 8.12%.
Year
Normal
One-Time
Projected Portfolio
Cash Flow ($)
Cash Flow ($)
Value ($)
Start
750,000
Year 1
25,000
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
25,000
Year 7
25,000
Year 8
25,000
Year 9
25,000
Year 10
25,000
750,000
75,000
125,000
(250,000)
$2,000,000
For illustrative purposes only. Actual returns would vary. This is a hypothetical portfolio that does not represent any specific investment
and does not include the effects of any taxes, fees, or charges that may be imposed with an actual investment.
9
Timing Matters – Hypothetical Returns
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Portfolio A
Value $
Portfolio A
Returns %
Portfolio B
Value $
Portfolio B
Returns %
962,500
25%
700,000
(10.0%)
1,228,125
25%
620,000
(15.0%)
1,635,156
25%
639,400
(13.0%)
1,795,874
8.3%
824,250
25.0%
2,217,051
15.1%
1,180,313
25.0%
2,554,655
14.1%
1,500,000
25.0%
2,792,048
18.1%
1,399,923
8.3%
2,537,843
(10%)
1,634,912
15.0%
2,182,161
(15%)
1,892,069
14.2%
1,923,485
(13%)
2,259,533
18.1%
Annualized Return = 8.12%
Relative to Goal: ($76,514)
Annualized Return = 8.12%
Relative to Goal: $259,533
For illustrative purposes only. Actual returns would vary. This is a hypothetical portfolio that does not represent any specific investment
and does not include the effects of any taxes, fees, or charges that may be imposed with an actual investment.
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Traditional Investment Expectations
Traditional Financial Analysis calculates the Required Rate of Return, 8.12%, for the portfolio to grow to
fund the objectives.
2,100,000
$2,000,000
$1,810,000
1,800,000
$1,650,000
$1,600,000
$1,500,000
1,500,000
$1,339,000
$1,215,000
1,200,000
$1,100,000
$929,000
900,000
$836,000
$750,000
600,000
300,000
0
start
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
For illustrative purposes only. Actual returns would vary. This is a hypothetical portfolio that does not represent any specific investment
and does not include the effects of any taxes, fees, or charges that may be imposed with an actual investment.
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The Real World
S & P 500 Index - Annual Returns - 2002 - 2011
30
20
10
0
-10
-20
-30
-40
2003
2004
2005
2006
2007
2008
2009
2010
2011
10 yr
avg.
Returns in % -22.08 28.36
10.76
4.8
15.65
5.42
-36.83 26.27
14.89
1.99
2.84%
2002
Source: S&P 500 data provided by PDR Services, LLC., solely owned by American Stock Exchange, LLC.
Past performance is not a guarantee of future results. Index performance shown is for illustrative purposes only and does not represent the returns of
any specific investment. The index performance shown does not reflect the impact of any taxes, transaction costs, management fees, or other
expenses that may be associated with certain investments. The index is unmanaged and an investor cannot invest directly in an index.
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The Dream vs. the Real World
The Dream World
$155,132
$160,000
$147,745
The dream world assumes
smooth and steady annual
growth projections to meet
targets.*
$140,710
$134,009
$140,000
$127,628
$121,550
$115,762
$120,000
$110,250
$100,000
$105,000
$100,000
$80,000
$60,000
$40,000
$20,000
$0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
SS & P Index - Annual Returns - 2002 - 2012
The real market’s performance is
volatile and can experience
dramatic spikes and drops in
value.**
30
20
10
0
-10
-20
-30
-40
2003
2004
2005
2006
2007
2008
2009
2010
2011
10 yr
avg
Returns in % -22.08 28.36
10.76
4.8
15.65
5.42
-36.83 26.27
14.89
1.99
2.84
2002
*For illustrative purposes only. Actual returns would vary. This is a hypothetical portfolio that does not represent any specific investment
and does not include the effects of any taxes, fees, or charges that may be imposed with the actual investment.
13
**Source: S&P 500 data provided by PDR Services, LLC., solely owned by American Stock Exchange, LLC. Past performance is not a guarantee of future results. Index performance
shown is for illustrative purposes only and does not represent the returns of any specific investment. The index performance shown does not reflect the impact of any taxes, transaction
costs, management fees, or other expenses that may be associated with certain investments. The index is unmanaged and an investor cannot invest directly in an index.
Probability-Based Analysis
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Probability-Based Analysis
•
Recognizes that the future is unknown, but history may
provide some guide to the range of possible outcomes
•
Is based on distributions of potential asset returns
•
Takes into account both the impact of the market’s volatility
and the timing of expected portfolio cash flows
•
Uses historical scenarios or statistical simulations to test key
analysis assumptions
•
Estimates the likelihood of achieving investment goals
15
Probability-Based Analysis Helps Answer Important
Questions
•
How much do I need to reinvest from my business sale to have a
reasonable probability of achieving my goals?
•
Can I retire early or have financial independence as I define it
and at what age?
•
How much should I fund into a family foundation or donor
advised fund?
•
What will be my financial legacy to my children?
•
How does adding a new goal affect my current important goals?
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The Probability-Based Process
Revisit Goals
And Priorities
Define Major
Life Goals
Acceptable and
Ideal Goals
Monitor
Progress
Goal Centered
Process
Implement
Allocation
Recommendations,
State of
Confidence
Source: Wealthcare Capital Management - Financeware
Prioritize
Goals
Probability
Test Goals
17
Monte Carlo Simulations / Probability-Based Analysis
•
First used to model atomic particle behavior during the
World War II Manhattan Project
•
Has a variety of uses: Atomic theory, aerodynamic
design, and financial analysis
18
Comparing Traditional and Probability-Based Analysis
Traditional Financial
Probability-Based
Analysis
Analysis
Identifies your maximum
risk tolerance and positions
you to experience it!
Monitors Investment
Performance
(what happened to the
markets?)
There is no method for
measuring confidence
Evaluates the necessary
level of risk
Monitors PROGRESS
(will I meet my Goals?)
Confidence, (comfort),
level kept in “balance”
Source: Wealthcare Capital Management - Financeware
Comments
1998 to 2000 Risk
Envelope Pushed
Past Performance is 100%
indicative of past
performance
How do you know if you will
achieve your goals?
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Example of a ProbabilityBased Financial Analysis
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Assumptions
Allocation
Assets
(values subject to change with market
fluctuation, and your monthly statement is
the official document)
All assets allocated according to the analysis
Taxable
$19,079,600
IRA
$519,000
529
$170,000
Total
$19,768,600
Total does not include venture capital holdings
Mortgage
Currently $1.062MM 3 year arm – 3.625% began 9/10
Social Security
No
Longevity
95
Tax Rates
39.6% federal 6.3% state 20% long-term cap gains
Annual Tax Assumptions
65% long-term capital gains and 25% annual turnover
Note: Important – The projections or other information generated by Financeware regarding the likelihood of various investment
outcomes are hypothetical in nature, do not reflect investment results and are not guarantees of future results. Results may vary
with each use and over time.
21
For illustrative purposes only. This is a hypothetical client scenario and does not represent individually tailored investment advice. Actual client results will vary.
Other Important Information
Other Important information
HELOC
$250,000 unused line of credit
Long-Term Care
None
Health Care Insurance
Covered by work
Disability
Covered by work
IRA Beneficiaries
Each other primary and contingent trust for under age child
Umbrella Insurance
$10,000,000 umbrella insurance policy
Life Insurance
$7,000,000 20 yr level term $3225 / yr ILIT
Other Advisors
CPA
LA
Estate Attorney
PA
P & C Insurance
State Farm
Note: Important – The projections or other information generated by Financeware regarding the likelihood of various investment
outcomes are hypothetical in nature, do not reflect investment results and are not guarantees of future results. Results may vary
with each use and over time.
For illustrative purposes only. This is a hypothetical client scenario and does not represent individually tailored investment advice. Actual client results will vary.
22
Ideal Goals – Probability 30%
Priority
Goals
Ideal Goals
Education Costs
$50,000
Per year plus 7% inflation
College Funding %
Pay 100%
2
Stay in Home
Yes
3
Risk
Portfolio E
55% Bonds
4
Retirement Cash Flow
$600,000
3.1% inflation
5
Keep Home 2
Yes
Possible estate asset
6
Retirement Age
50
7
Annual Savings
1
401k
$18,000
per year / includes match
Taxable
$0
Spend more now
Foundation Funding
8
9
DAF
Estate Goal
$2,000,000 additional
Currently have roughly $1.3MM in donor advised fund And $3MM in
private family foundation
Each child receives no more than $20,000,000 in addition to their
education
Note: Important – The projections or other information generated by Financeware regarding the likelihood of various investment
outcomes are hypothetical in nature, do not reflect investment results and are not guarantees of future results. Results may vary
with each use and over time.
For illustrative purposes only. This is a hypothetical client scenario and does not represent individually tailored investment advice. Actual client results will vary.
23
Acceptable Goals – Probability 95%
Priority
Goals
Acceptable Goals
Education Costs
$50,000
Per year plus 7% inflation
College Funding %
Pay 100%
2
Stay in Home
Yes
3
Risk
Portfolio D
40% Bonds
4
Retirement Cash Flow
$250,000
3.1% inflation
5
Keep Home 2
No
Sell at age 75
6
Retirement Age
55
7
Annual Savings
1
401k
$18,000
per year / includes match
Taxable
$500,000
Save more now
Foundation Funding
8
9
DAF
Estate Goal
$0 additional
Currently have roughly $1.3MM in donor advised fund and $3MM in
private family foundation
Providing their education
Note: Important – The projections or other information generated by Financeware regarding the likelihood of various investment
outcomes are hypothetical in nature, do not reflect investment results and are not guarantees of future results. Results may vary
with each use and over time.
For illustrative purposes only. This is a hypothetical client scenario and does not represent individually tailored investment advice. Actual client results will vary.
24
Recommended Goals – Probability 85%
Priority
Goals
Recommended Goals
Education Costs
$50,000
College Funding %
Pay 100%
2
Stay in Home
Yes
3
Risk
Portfolio E
4
Retirement Cash Flow
$600,000
3.1% inflation
5
Keep Home 2
No
Sell at age 75
6
Retirement Age
55
7
Annual Savings
1
401k
$18,000
Per year / includes match
Taxable
$500,000
Save more now
Foundation Funding
8
9
Per year plus 7% inflation
DAF
Estate Goal
$0 additional
Currently have roughly $1.3MM in donor advised fund and $3MM in private
family foundation
Providing for their education
Note: Important – The projections or other information generated by Financeware regarding the likelihood of various investment
outcomes are hypothetical in nature, do not reflect investment results and are not guarantees of future results. Results may vary
with each use and over time.
For illustrative purposes only. This is a hypothetical client scenario and does not represent individually tailored investment advice. Actual client results will vary.
25
Risk Tolerance through
Probability-Based Analysis
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Risk Tolerance Chart - Percentages
Potential Average
Return (%)
Odds of Losing
Money in Any OneYear
Worst Year of 80
Years (%)
Worst Year of 35
Years (%)
Portfolio A
12.50
1 in 3
(46)
(36)
Portfolio B
12.00
1 in 4
(41)
(32)
Portfolio C
11.30
1 in 5
(37)
(28)
Portfolio D
10.00
1 in 6
(28)
(18)
Portfolio E
9.00
1 in 7
(22)
(10)
Portfolio F
7.80
1 in 8
(15)
(3)
Past Performance is not a Guarantee of Future Results
Source: Wealthcare Capital Management – Financeware
IMPORTANT: The projections or other information generated by Financeware regarding the likelihood of various investment
outcomes are hypothetical in nature. They do not reflect actual investment results and are not guarantees of future results.
27
Risk Tolerance Chart – Based on $10,000,000
Potential Average
Return (%)
Odds of Losing
Money in Any OneYear
Worst Year of 80
Years
Worst Year of 35
Years
Portfolio A
12.50
1 in 3
$5,400,000
$6,400,000
Portfolio B
12.00
1 in 4
$5,900,000
$6,800,000
Portfolio C
11.30
1 in 5
$6,300,000
$7,200,000
Portfolio D
10.00
1 in 6
$7,200,000
$8,200,000
Portfolio E
9.00
1 in 7
$7,800,000
$9,000,000
Portfolio F
7.80
1 in 8
$8,500,000
$9,700,000
Past Performance is not a Guarantee of Future Results
Source: Wealthcare Capital Management – Financeware
IMPORTANT: The projections or other information generated by Financeware regarding the likelihood of various investment
outcomes are hypothetical in nature. They do not reflect actual investment results and are not guarantees of future results.
28
Conclusions
•
Conventional financial analysis methods don’t fully reflect the uncertainty of future
market behavior
•
Even the most sophisticated statistical tools cannot eliminate uncertainty. They are not
crystal balls.
•
Historical scenarios and statistical models can be used to test the plausibility of
financial assumptions and help to guide progress toward goals.
•
Average annual returns over a specific time period, such as 5 or 10 years, are just that
– an AVERAGE for that time period – returns vary over time, year over year, both up
and down and are not achieved in a straight line. Another name for this is volatility.
•
The interaction between market volatility and the timing of cash flows both have a
major impact on investors’ ability to achieve their goals.
•
Probability-based analysis helps to avoid unnecessary risk while aiding in achieving
goals that are truly important to people’s lives.
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Important Disclosures
S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock
market. An investment cannot be made directly in a market index.
This material does not provide individually tailored investment advice. It has been prepared without regard to the individual
financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material
may not be suitable for all investors. Morgan Stanley Smith Barney LLC recommends that investors independently evaluate
particular investment and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness
of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Important: The projections or other information generated by Financeware regarding the likelihood of various
investment outcomes are hypothetical in nature and do not reflect investment results and are not guarantees of future
results. The analysis results will vary with each use and over time.
Analysis Methodology
The general methodology has these common characteristics as user inputs:
1.
One or more estimated financial spending goals.
2.
One or more financial resources that may be invested to generate funding for current or future financial goals.
3.
One or more estimated sources of cash flows into the analysis.
4.
One or more investment portfolio designs based either on the risk and return characteristics of portfolios linked to financial
resources as a whole or multiple portfolio designs based on those resources’ tax treatment characteristics and/or time
periods during which a portfolio design is to apply.
5.
Tax rate assumptions, portfolio management, investment advisor and related investment expenses and portfolio turnover.
6.
Client information necessary to the calculation of estimated income taxes on the client(s)’ portfolio and social security
benefits.
7.
Client and spouse or life partner date of birth, life expectancy (or random mortality analysis can be used).
30
Important Disclosures
These inputs are then calculated together in chronological sequence (cash inflows and outflows) in annual periods for each year
through the end of the user selected planning period. The cash flows include simulated target portfolio investment results (gains
and loses), net of estimated taxes, using one of three methods (the three valuation or simulation methods available are Historic
Audit, Wealth Simulator, and Monte Carlo). The process is repeated 1,000 times to generate 1,000 “lifetimes” of hypothetical
investment results and overfunded or underfunded wealth management results for each programmatic run. The resulting data
comprises a “analysis” or “analysis scenario”.
Limitations of the Analysis and Sensitivity of Assumptions to Analysis Results
The results of all simulated trials used to evaluate and describe a hypothetical distribution of outcomes, but do not represent a
forecast or prediction of actual expected investment or financial outcomes.
Morgan Stanley Smith Barney offers a wide array of brokerage and advisory services to its clients, each of which may create a
different type of relationship with different obligations to you. Please visit us at http://www.morganstanleyindividual.com or
consult with your Financial Advisor to understand these differences.
Morgan Stanley Smith Barney and its Financial Advisors do not provide tax or legal advice. Individuals should consult their
personal tax advisor or attorney for matters involving taxation and tax planning and their attorney for matters involving personal
trusts and estate planning.
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