Reading 15: Managing Individual ....tor Portfolios －LOS n contrast, planning, versus

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 4: Private Wealth Management
Reading 15: Managing Individual Investor Portfolios
LOS n, (Part 1): Compare and contrast traditional deterministic versus Monte Carlo approaches to retirement planning.

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Which of the following statements about approaches in retirement planning is FALSE?

A) Monte Carlo techniques take into account probabilities for input variables.

B) Deterministic planning techniques use multiple values for economic and financial variables.

C) Monte Carlo techniques allow investors to see a range of outcomes.

D) Monte Carlo techniques can be used by most individual investors.

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Answer and Explanation

Deterministic planning techniques use single values for economic and financial variables. Monte Carlo (MC) simulations generate a probabilistic forecast of retirement period values. Although MC analyses require computing powers, the advent of computers available at low cost provides the individual investor a means for incorporating probabilities into retirement planning process.

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Which of the following inputs is NOT used in both deterministic and probabilistic analyses in individual retirement planning?

A) Desired retirement age.

B) Input variable probabilities.

C) Current income.

D) Assets owned.

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Answer and Explanation

In both approaches, the individual supplies a similar set of personal information, including the above as well as age, savings, etc. The difference between deterministic and probabilistic analyses is that deterministic planning techniques use single values for economic and financial variables. Monte Carlo (MC) simulations generate a probabilistic forecast of multiple retirement period values. Only Monte Carlo simulation would require the input of variable probabilities.

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Which of the following statements about Monte Carlo simulation is TRUE? Monte Carlo simulation:

A) forecasts a more accurate risk/return tradeoff than a deterministic approach.

B) is best when it uses only historical data.

C) typically produces approximately 100 trials.

D) offers a yes/no answer concerning whether the individual will reach a particular goal.

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Answer and Explanation

History provides a view of only one possible path among the many that might occur in the future. It is difficult to estimate expected returns using historical figures because of the volatility factor. Monte Carlo analysis produces probability distribution by tabulating the outcomes of a large number (often 10,000) of simulated trials. Deterministic models offer yes/no answers with respect to meeting a particular goal.

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Deterministic approaches differ from Monte Carlo approaches in that deterministic approaches:

A) generate ranges of outcomes whereas Monte Carlo approaches generate single numbers.

B) use probability forecasts whereas Monte Carlo approaches use best estimates.

C) provide higher accuracy than Monte Carlo approaches.

D) generate single numbers whereas Monte Carlo approaches generate a range of outcomes.

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Answer and Explanation

Monte Carlo approaches rely on probabilistic inputs to generate a range of outcomes that may provide better information than any method that generates a single number, like deterministic approaches.

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When planning for retirement, an individual investor may wish to use a Monte Carlo approach over a deterministic approach because:

A) Monte Carlo approaches are simpler and quicker to implement.

B) Monte Carlo approaches provide a better analysis of outcome ranges than the single wealth figure estimate generated by deterministic approaches.

C) deterministic approaches often consider probabilities that may not be appropriate for the individual.

D) deterministic approaches use inappropriate inputs.

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Answer and Explanation

Monte Carlo approaches generate ranges of outcomes that can be associated with probabilities of their occurrences. Although slightly more involved in implementation, and sometimes taking longer to generate, Monte Carlo generated ranges and or probabilities may better indicate to the client realistic retirement opportunities.

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Probabilistic outcomes generated by a Monte Carlo approach to retirement planning do NOT generate which of the following?

A) Potential risk/return tradeoffs.

B) Better incorporation of tax implications.

C) Higher probabilities of meeting high return expectations.

D) Better incorporation of compounding.

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Answer and Explanation

No forecasting method can affect probabilities of meeting high return expectations. Forecasting methods can only indicate future outcomes, and in the case of Monte Carlo approaches, potential risk/return tradeoffs can be generated, as well as better incorporating tax implications and compounding effects.