Predicting Retirement: Dynamic Behavior Analysis Revisited

A few weeks ago I wrote Proof of Geek in an attempt to share my enthusiasm for my newly acquired ability to perform the most up to date retirement analysis through a process called Dynamic Behavioral Analysis. Unfortunately, many people told me that even after they read the post multiple times they still had no clue what behavioral analysis is all about. Now that I have experience using the tool and explaining it to several clients, I think I can explain it better.

When it comes to financial analysis, the techniques are constantly evolving.

The earliest and simplest models are based on averages. A pool of money which earned an average of 5% would be calculated to grow at 5% each and every year. Averages work over the long haul but they have no impact on short term results. The volatility and variables of the real world are not taken into account and as a result the accuracy of such an analysis would be suspect.

For several years planners have been incorporating Monte Carlo simulation into their plans. Monte Carlo uses statistical modeling to account for the real world fluctuations. The model is run through thousands of simulations which all fit within statistical parameters. By examining the results of these multiple variable simulations we can then determine the probability of a retirement plans success.

Now the researchers have found a flaw with Monte Carlo planning. It fails to incorporate human behavior into the model. When investments are doing better than average, we tend to spend more than we had planned. Conversely, when investments are under-performing we tend to spend less than we had hoped. Dynamic Behavioral Analysis adds these natural tendencies to the analysis. It starts with a Monte Carlo simulation but when the returns in a given year are above average, we also assume that there is an increase in spending over budget and vice versa. The module I use also allows me to define parameters for allowable spending based on good years, bad years, and overall spending limits as a percentage of assets. Now, the results are not just the probability that the plan will be successful. After running dynamic behavioral analysis I can provide the probability that a client can retire within a range of years. Then, for every year, we see the probability of not running out of money through out retirement as well as the average percentage of the inflation adjusted budget which was spent.

By understanding the sustainability of retirement in a given year as well as the impact on their budget, I find clients are becoming very confident in their retirement decisions. Questions such as "should we continue to work or retire now?" or "can we afford the retirement we want?" are getting easier to answer.

Panama Retirement by thinkpanama

Comments

[ThinkPanama]

Thank you Art for kind reference.

[Art Dinkin]

You are more than welcome. Thanks for stopping by and hope to see your comments in the future.