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Friday, 30 November 2007

Swings and Roundabouts

With the market recovery in the past couple of days it looks like this month's net worth figure will just manage to break even. My stock investments are still down around 5% for the month but this was offset by a jump in the estimated values for my home and investment property. Unfortunately I already have the raw data for calculating next month's house price estimates and about half of this month's real estate gain will be given back next month. Perhaps the market has bottomed out and next month will gain enough for net worth to stay relatively constant. If nothing else this is proof of the value of having an diversified allocation of uncorrelated assets.

Of course it won't always be the case that one asset class is doing well when others are struggling - I'm sure there will be periods when everything in my portfolio is doing badly, and the rare 'perfect storm' when everything is going gang-busters. In the inevitable bad times an asset allocation on the efficient frontier isn't enough to see you through, you also need to take the long term view and stick to your plan. So it's especially important to have a plan that is based on realistic expected returns (historic returns over 20, 50 or 100 years may not be replicated over your 10-20+ year investment time frame, but it's the best guess available), and which has a risk (volatility) level that matches your risk tolerance. When I get bored and want to plan around with my investment plan I take my current asset allocation, grab some historic annual returns for the past 20 or 50 years, and use a spreadsheet to simulate my portfolio using randomly selected returns. This sort of "Monte Carlo" simulation will show you what the most likely outcome of your plan is. But of more interest is to see how your portfolio might perform in particularly good or bad periods. If you translate the bad patches into prospective dollar losses you can get an idea of how hard it will be to stick with your plan in those trying times. Looking at the worst performing runs of your simulation will also give you an idea of how comfortable you would be in retirement in a likely worst case scenario. This might help motivate you to live frugally and up your savings rate a notch or two. I always figure it's better to live frugally by choice while I'm working than to have an impoverished lifestyle when I'm retired.

Copyright Enough Wealth 2007

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