Goals-Based Portfolio Theory

CHAPTER 10Fragility Analysis of Goals‐Based Inputs

“You are only entitled to the action, never to its fruits.”

—Bhagavad Gita

“We usually just put in 3% for an inflation estimation. It doesn't really matter too much, anyway,” a trainer responded to my question about the new financial planning software the firm had brought on. It carried numerous assumptions: the returns and volatilities of various assets, the future inflation rate, medical cost increases, even future tax estimations. As a young financial advisor, I understood few of the other inputs, but I could grasp inflation, so that is what I asked about. Despite my trainer's answer, I later played with the inflation assumptions in the tool and found that, contrary to his response, the inflation assumption does matter. It matters quite a lot, in fact. In a few of the simulations I ran, the difference between a 3% inflation rate and a 5% inflation rate over 25 years was the difference between retiring with near certainty and not retiring with near certainty. Counter to my intuition, adjusting the market return assumptions by the same 200 basis points had a much smaller effect. This left me with a question: Which assumptions matter most to goals‐based investors? We know that all our myriad forecasts are wrong to some extent. With limited time and resources, what should we, as practitioners, focus on getting as right as possible, and what can we leave for broader approximations?

I really had no way of effectively answering ...