Monty Hothersall

Put Science on the Shelf

Monty Hothersall — Tue, 20 Jul 2010 20:51:26 +0000

Jack,

It takes a lot of guts to write an article (Smart Money, June 2010) that seriously challenges to status quo in finance. I loved it! And to add to your “dice math” concept, remember that tens of millions of Americans use financial planning software and online retirement calculators that run Monte Carlo simulations to determine investment probabilities. Trying to reduce “uncertainty” to a probability figure is incredibly dangerous and it creates a false sense of security.

I always enjoy original thinking. Keep up the good work.

Monty Hothersall

The Goose and the Gander

Monty Hothersall — Tue, 20 Jul 2010 20:37:37 +0000

In finance, many use the capital asset pricing model (CAPM) to determine a single expected rate of return of an asset (e.g., 15% for IBM stock). Once determined, this single expected rate of return or discount rate is used to discount the future cash flows produced by the asset being valued. I whole-heartedly support the CAPM theory and believe its founders helped the financial markets to become more efficient.

But I find interesting that many people who support this theory believe that a single expected rate of return should not be used to forecast a specific asset’s return. Instead, they promote Monte Carlo Simulation as the appropriate technology to generate many possible returns to assess the risks.

I’d be very interested to know how these talking heads in the finance world can reconcile these opposing approaches. There’s an old saying: What’s good for the goose is good for the gander.

Monty Hothersall

A Pecking-Order in Personal Finance

Monty Hothersall — Thu, 04 Feb 2010 21:06:10 +0000

Experienced and astute planners in business, the government, or in the military will create strategic plans prior to developing their associated tactical plans. After which, they will position their resources to implement their plans. Just imagine the chaos, for example, if our military planners didn’t follow this pecking order. Their direction would be aimless due to a lack of alignment between their short-term tactical plans with an intermediate- to long-range strategic solution. And without well integrated short-term plans the positioning of aircraft, tanks, and troops would be ineffective.

This brings me to way most American households conduct financial planning. I’ve seen far too many families position their resources (e.g., investments, insurance policies, houses, cars) and develop tactical plans (i.e., 12 month budgets) prior to or without creating a strategic plan (i.e., intermediate to long-range planning). And just like in the military example above, when the cart is placed before the horse, expect chaos.

Monty Hothersall

The 5-year family budget: A missing link?

Monty Hothersall — Wed, 28 Oct 2009 16:27:38 +0000

As you know, tracking household income and expenses in a monthly budget is a must for good financial management. But without aligning this important short-term budget with an intermediate-term budget, do-it-yourself planners can go in the wrong direction and miss their financial goals. Moreover, the integration between intermediate- and long-range planning is absolutely essential in order to produce useful results from the long-range plan.

So, how many families actually have a 5-year budget? The answer is very few. To learn more about this critical component in financial planning and discuss how Financial Fate’s free solutions can help, please let me know.

Monty Hothersall

Are financial projections a lot of hocus-pocus?

Monty Hothersall — Thu, 30 Jul 2009 19:36:40 +0000

Can Financial Fate software predict your financial future and quantify your financial uncertainties? The answer is a resounding no since uncertainty is—by definition—uncertain. But it does help to evaluate the possible events in your future and gives you a realistic indication of their impact on your overall financial picture. And this is the key to successful financial planning: viewing and challenging your underlying assumptions, updating and revising your position and goals, and always questioning the results.

Obviously, this is not a 10 minute exercise. Financial Fate is not a soothsayer’s tool taking a few of your input variables, automatically running all possible scenarios, and reaching the final verdict all in one fell swoop. But it will provide you with greater vision into the future and better decision making if you’re willing to get involved with your personal finances. For instance, if you hear on the news that Medicare eligibility may be pushed back to the age of 68 rather than 65, you can key this new assumption into Financial Fate to measure your financial sensitivity to this possible event. If this change in Medicare policy yields little impact to your financial projections, you can breath a sigh of relieve. But if the impact is severe and the possibility of this change is real, then you may have to make adjustments to other areas of your financial plan.

This process is the essence of good financial planning. Regardless of which part of your financial life—investments, income, expenses, or taxes—is being evaluated, the process of planning is much more important than the plan itself.

Monty Hothersall

Corruption, Greed, and Incompetence?

Monty Hothersall — Wed, 13 May 2009 20:54:37 +0000

Most contend that the recent mortgage meltdown was caused by corruption, greed, and incompetence. The headlines and sound bites support this idea but lack the deep reporting to prove their case. To demonstrate, in regards to the alleged corruption, I haven’t noticed a spike in the number of mortgage-related “perp walks” in the papers or on the evening news. How did I miss all of these examples of corruption?

Second, pure greed by itself actually would have drawn many hedge fund managers and their counterparts to short-sell mortgage-related investments during the bubble. Just think of the profits and bonuses for the few who did. Therefore, one can’t rightfully blame greed when the greedy people actually missed a big opportunity to make money and deflate the growing bubble. (And to be sure, the bubble never would have reached its size had there been more greedy short-sellers to offset all the buyers.)

And finally, it seems to me that a widespread miscalculation of risk among sophisticated buyers is a more accurate description of what occurred than just the simple incompetence of a few. After all, the players who contributed to the buying frenzy were not only the Wall Street risk managers, but also academics (including Nobel Laureates), financial journalists, foreign governments, highly-regulated foreign banks, Freddie and Fannie, and so on. This long list of participants, with very few dissenters, tells me that the many sophisticated parties who do their due diligence were just wrong.

But how did this widespread, devastating mistake happen? How did these various groups consistently miscalculate the level of risk and fail to anticipate this financial tsunami?

To find the root cause, it’s important to identify some common threads throughout these groups. The most obvious was the computer risk models which generated thousands, if not millions, of simulations but provided very little transparency. I believe risk management and finance professionals now understand that computer simulation models can easily create a false sense of security in an “uncertain” environment. And without transparency, the investors couldn’t challenge the model’s underlying assets and assumptions nor could they question its results.

Monty Hothersall

My retirement plan was 98% likely to succeed

Monty Hothersall — Wed, 06 May 2009 20:56:51 +0000

If you’ve ever received retirement planning results from a Monte Carlo Simulation (MCS) model, you might be surprised how much those results have changed over the past 12 months. And this probably makes sense given the market’s free fall, right?

Well, not exactly. To use an example, let’s say your results from last year’s MCS planning said you had a rock-solid 98% chance of successfully meeting your retirement goals. (But today it’s a much different story.) So, was the 98% result a realistic number and you just had some unfortunate luck? Not likely. The problem is the Monte Carlo Simulations were based on a risk model where the distributions of market returns were “normal” like a bell-shaped curve. Where in reality, the actual market returns are far from normal because they are “uncertain.” And since the underlying assumptions of MCS were not valid, the 98% result was not valid. Maybe it should have been 68% or even 38%, who knows?

Moreover, I hope the marketplace doesn’t get fooled again by believing these problems will be solved merely by using fatter-tailed distributions in MCS. Trying to reduce “uncertainty” to any probability distribution (i.e., risk) is incredibly dangerous and again it will create a false sense of security.

Investors need predictive financial-modeling tools that allow them to challenge not only the rates of return by asset class but also the underlying assumptions, such as targeted future asset allocations. And they must be able to realistically forecast the volatility of their free cash-flows which will be available for future investing. This would allow investors to control their scenario planning rather than “flying on auto-pilot” with a technology that wasn’t designed for predicting market returns with all its inherent uncertainty.

Monty Hothersall

How to Make it Last

Monty Hothersall — Mon, 20 Apr 2009 14:49:46 +0000

The Smart Money article in May ’09 about retirement planning models (“How to Make it Last”) does something rarely seen in reporting on these simulation models: It questions their results. And advisors aren’t the only ones relying on Monte Carlo simulations. Millions of do-it-yourselfers using online retirement calculators use this technology without the ability to challenge the underlying assumptions. This not only creates a false sense of security regarding future investment returns but also tends to divert attention from critical cash-flow drivers such as future healthcare expenses.

Monty Hothersall

Financial Forecasting using the Rear-View Mirror

Monty Hothersall — Tue, 17 Mar 2009 21:16:09 +0000

Financial forecasting models that rely exclusively on the rear-view mirror will get us in trouble every time (e.g., Wall Street’s mortgage related investments). Companies such as T. Rowe Price offer these types of Monte Carlo tools to investors who are planning their retirements because they’re easy to use. But unfortunately, they just create the illusion of taming an uncertain market and allow the “rear-view mirror” to control the “steering wheel.” And since future market returns are by definition uncertain (which is not the same as being risk based), I think users should be given the flexibility and control to run what-if scenarios rather than being force fed historical returns for extrapolation.

Monty Hothersall

Online Retirement Calculators: The Mental Equivalent to Diet Pills

Monty Hothersall — Thu, 05 Mar 2009 14:22:18 +0000

Most personal finance journalists do a great job warning their readers of possible scenarios such as health-care costs growing 2.5% faster than the economy or the age of Medicare eligibility changing. They also implore their readers to “run their numbers” to customize a long-range plan in order to understand the impact of these real-world possibilities.

Unfortunately, the online retirement calculators recommended by most of these same journalists are not capable of handling these types of critical questions. While these calculators are quick and easy to use, they don’t offer the flexibility to view and challenge the underlying assumptions. So, while most personal finance journalists have been prescribing quick and easy diet pills, what people really need is more diet and exercise.

Monty Hothersall