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Tools and insights
LDI strategy for retail investors using Monte Carlo method
Viswanathan M B, FCA, CFA, FRM
Tools and insights
www.moneyshastra.com 2
Our two cents
Monte Carlo method might be difficult for advisors to understand. But, we believe, the insights that a simulation
based framework offers is far more easy to convey and understandable to end investors.
Further, its ability to factor various risk factors and investor specific issues make it our only approach to financial
planning for individual investors.
www.moneyshastra.com 3
About MoneyShastra.com
An online portal providing useful tools and insights to retail investors
Provide advice on strategic asset allocation using our web interface
Aspire to become a full fledge robot advisory firm
www.moneyshastra.com 5
Our view on traditional wealth management
Focuses on wealth maximization
Considers the overall risk tolerance/aversion of investors
Decisions on strategic asset allocation is qualitative
Forecast and risks are calculated, if at-all, using deterministic approaches using mean-variance framework
www.moneyshastra.com 6
Our view on investors
Retail investors do not decide based on mean-variance framework
They are not risk neutral
They hope for luck; especially, if they realize they don’t have enough money Sometimes, they take risk because they believe they wouldn’t actually face the
consequence
Their risk tolerance for each investment and need varies based on their mental bucket More risk averse if goals are indispensable as compared to goals that are optional
www.moneyshastra.com 7
Traditional approach and investors: Our view on mismatch
It is impossible to explain lay investor the risk in their strategy using mean-variance framework
The math is too complicated for most of them to understand
Qualitative “common-sense” explanation about risk may not cut ice; especially, if investors believe they won’t face consequences of their action
Earmarking a portfolio towards a particular goal does not mean that investors will not use it for other purpose if they see the “need” to do that
www.moneyshastra.com 8
How does Monte Carlo method help?
Monte Carlo method enables optimize an asset allocation by considering various scenarios
Various risk factors, especially low probability high impact risk factors, can be incorporated and quantified
Risk aversion or tolerance for each individual goal can be incorporated using a suitable penalty function
Most importantly, can help provide insight that any common investor can appreciate
www.moneyshastra.com 9
The insights provided by our approach
Our approach to financial planning can provide various insights that are far easier and more useful to end investors
Some of the insights include the following:
The chances that their goals can be met using their current asset allocation
The chances of having funds to meet an unexpected emergency
The optimal asset allocation that enables the end investor to maximize their chances of meeting their goals and uncertain emergencies without losing focus on wealth maximization
The maximum, minimum and most likely value of investments
The chances that they would have an amount that is more than or less than a specific amount
www.moneyshastra.com 10
Some of the insights that can be provided (1/2)
The approach can tell the investors the chances of meeting their goal using their asset allocation
Asset Allocation
Equity
Gold
Debt
Goal
Retirement
Home purchase
World Tour
Year
2015
2016
2017
2018
Equity, 33.7%
Gold, 34.0%
Debt, 32.3%
96%
70%
60%
Retirement
Home purchase
World Tour
Chances of meeting goal Chances of missing a goal
IDEAL ASSET ALLOCATION PROBABILITY OF SUCCESS
www.moneyshastra.com 11
(1,000.0)
(500.0)
-
500.0
1,000.0
1,500.0
2,000.0
2,500.0
3,000.020
15
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
2035
2036
2037
2038
2039
2040
2041
2042
Expected Max Min
The insights Monte Carlo method provides (2/2)
The approach can tell us how much the assets are likely to be at different points in future
www.moneyshastra.com 13
What do we do?
Identify the ideal asset allocation that maximizes the chance of meeting your goal
Investors have several constraints that prevents them from saving the ideal amount that they need to meet various goals
We identify the asset allocation that enables them to maximize their chance of meeting goal with special focus on indispensable goals
Our model focuses on reducing the chances of shortfall as well as the amount of shortfall
www.moneyshastra.com 14
How we do it?
Our model considers several random factors that affects an investor’s financial life
It includes return on markets, inflation, personal emergencies
Several thousand trials involving several thousand scenarios are run to identify an asset allocation that result in the least amount of expected shortfall
www.moneyshastra.com 15
Our model, in a nutshell (1/2)
Step 1: Identify various goals and its importance
Step 2: Identify the value of current investment and the amount of annual savings
Step 3: Identify initial asset allocation
Step 4: Generate values for key random variables using stochastic process
www.moneyshastra.com 16
Our model, in a nutshell (1/2)
Step 5: Calculate path dependent present value of assets and liabilities
Step 6: Levey a penalty on deficit and surplus (negative penalty on surplus)
Step 7: Run simulation involving several thousand iterations to identify the shortfall
Step 8: Adjust the asset allocation and repeat step 6 and 7 several thousand times
www.moneyshastra.com 17
Fundamental premise of our model
Every financial goal of an investor is a liability he needs to meet
Investors can afford to miss some goals that are not important
Investors associate priority to each goal
Investors risk aversion/tolerance varies based on the importance of goal
www.moneyshastra.com 18
The risk and risk objective in our approach
Risk represents the probability of not meeting a goal
The objective of asset allocation is to minimize the chances and amount of shortfall
Reduce the likelihood of not having sufficient money to meet the goal
And, in any case if shortfall arises, reduce the amount of shortfall
For example, if an investor wants to save Rupees six crores towards his retirement corpus, the asset allocation should maximize the chance of having the amount. And, in cases where the amount falls short, the asset allocation should focus on reducing the deficit as much as possible
www.moneyshastra.com 19
Key assumptions in our model: Accumulation phase
Constant asset allocation ratio through the accumulation phase:
The asset allocation across different years would remain same
Static asset allocation: The model assumes that asset allocation, once determined shall remain constant
In reality, we periodically review the market conditions and personal financial position of the investor to change the asset allocation, if required.
Portfolio rebalancing at the end of each year
www.moneyshastra.com 20
Key assumptions in our model: Consumption phase
Assets to be distributed using a waterfall approach
Investment would be first utilized to meet the top priority goal
Remaining assets would be used to fund the next priority goal
And so on…
www.moneyshastra.com 21
Other important random factors considered in the model
Change in correlation between asset returns under different regimes
Tracking error: Standard deviation of alpha
Transaction cost
Taxation
www.moneyshastra.com 23
@Risk helps generate random numbers easily
Different variables in our model follow different type of distributions
For instance while asset returns may be assumed to follow normal distribution, unexpected personal emergencies may follow a binomial distribution; the expense on account of that may follow a discrete distribution
While MS Excel has inbuilt functions to generate normal, lognormal and uniform random distribution, other distributions require fair amount of effort
@Risk’s distribution functions enable generate random numbers across several distributions, easily
Risk optimizer gives us the brute force we need
A model to optimize asset allocation requires that several thousand trials are run with several asset allocation
Risk optimizer provides the ability to run several thousand trials each involving several thousand iterations in order to arrive at optimal asset allocation
Most importantly, we find risk optimizer keeps the system much more stable even as it runs several Ghz of process
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