Few of us would want to gamble with our future. Imagine you’re in a casino, and your retirement depends on playing the roulette table. If you win, your retirement is comfortable. If you lose, you go broke. And yet the EvolveMyRetirement® app proudly uses Monte Carlo simulation, named after the famous casino. Does that mean we’re suggesting you gamble away your retirement? Of course not!
Playing the casino game
You might get the impression that using Monte Carlo simulation means you’re playing the odds. Maybe you imagine an unscrupulous ‘cowboy’ financial adviser who thinks of his clients as statistics; as long as he has a reasonable success rate, he’s quite happy to take risks with other people’s money. Fortunately reputable advisers are not so cavalier. But you can see how there could be a difference of perspective between the adviser and the client. The advisor has many clients, giving some safety in numbers. But the client only lives once, and so has only one roll of the ‘dice’: failure is not an option.
Understanding the risks
The reason that EvolveMyRetirement® uses Monte Carlo simulation is not to play the odds, but to measure risk. Once you know the risks you’re taking, you can decide whether they’re within your comfort zone. Most people would prefer to take no risk at all, and still have a luxurious retirement. That might be possible if you’re lucky enough to have a generous gold-plated defined benefit pension. But these are becoming much rarer, and you’re more likely to need to rely at least in part on investments (defined contribution pension, ISA, etc.). In that case, your decisions on how to invest will naturally reflect your attitude to risk. There are actually two different types of financial risk.
The first type of risk is the long-term risk of running out of money during your lifetime. You only live once, so you can’t rerun your life once you’ve run out of retirement funds. This means making decisions over time that align with your circumstances and preferences. Ideally, setbacks should be manageable within your lifetime, and the risk of not recovering should be low enough for your peace of mind.
The second type of risk is the short-term risk of investments falling in value. Some types of investment fluctuate more wildly than others. This is known as ‘volatility‘. For example, equities tend to be more volatile than bonds. But in the long term, a diversified portfolio of equities is likely to outperform a similar portfolio of bonds. But the equity journey may be a bit of a rollercoaster ride. If most of your investments are in equities and there’s a stockmarket crash, you might not have the stomach to stay the distance.
Mitigating the risks
An ultra‑cautious approach might involve favouring bonds during working life and purchasing an annuity at retirement. This tends to work best for those with higher incomes, as lower‑risk approaches generally require larger resources to support a comfortable lifestyle.
A more cautious approach might involve holding some equities earlier in life and gradually shifting toward bonds before retirement, potentially combined with purchasing an annuity at retirement. This transition is known as a ‘glide-path‘. At retirement, you’d buy an annuity to give you a guaranteed income. This approach was quite popular before pension freedoms.
Moving from cautious to ‘balanced’, you might start with a higher proportion of equities, but again with a glide-path. This time you might leave some of your investments in equities at retirement. After retirement, you might choose to buy an annuity with part of your portfolio, leaving the rest to grow.
A more aggressive approach might be to invest in equities throughout your working life, and to stay invested in equities after retirement. This obviously has higher short-term risks, but for some people it can mitigate long-term risk.
Choosing a strategy is not like gambling in a casino. It’s more like selecting an insurance policy. And the available strategies are much more complex than the four possibilities above. EvolveMyRetirement® uses Monte Carlo simulations to evaluate your strategy. But more than that, it can generate your strategy, based on your attitude to risk.