Dynamic Asset Allocation and Monte Carlo Simulation, What You Don’t Know Can Hurt You!

By John Berzellini

The combination of Modern Portfolio Theory,  the Brinson Study, index funds, Exchange Trade Funds (ETF), derivatives and recent stock market volatility has caused a proliferation of an investment strategy called Dynamic Asset Allocation (DAA). DAA attempts to produce high returns irrespective of the performance of the indices used to build portfolios. The “words high rates of return” imply the use of market timing, leverage, alternative investments, and additional risk.

As with strategic asset allocation,  a DAA portfolio’s return is largely decided by the interaction of the various asset classes comprising the portfolios, however a dynamic asset allocation is changing based on some complicated mathematical algorithm or merely a predictions of the future. Of course, in the final analysis, the mathematical algorithms are also predictions of the future.  In many cases validation of the successful DAA model portfolio is done thru back testing. Back testing is a measure of how well a portfolio would have performed had it been in existence.  Maybe FINRA should require the statement, “hypothetical performance is not indicative of future performance”.

These back tested DAA portfolios are sometimes combined with withdrawal programs supported by Monte Carlo simulations and sold to the public as retirement planning. The sale  goes something like this “ Our DAA Model Portfolio was tested with 10,000 Monte Carlo simulation trials  proving you can withdraw 7% and not outlive your retirement savings in 35 years 95% of the time.   Depending on the Monte Carlo software used, the same data can produce output ranging from 50% to 95% success ratios.  The dishonesty with this type of money management focused retirement planning is the computer programs and graphic output can lead us to believe a highly subjective topic is quantifiable.

While listening to our favorite sports talk shows or browsing the internet for a solution to the low interest rate environment; if we hear claims that sound too good to be true, there probably not true. When I was an IRS agent, the agency constantly advertised to taxpayers, that if an investment in a limited partnership seemed too good to be true, it’s probably not true. As it was then it is now, however, this game is far more serious because it has the potential to change your golden years into years of fears.

Remember the famous quote attributed to Mark Twain “there are liars, dam liars and statistics”.

See also: Withdrawing Money from Retirement Savings, Do We have enough to Retire?