Monday Morning: Don’t gamble with your web-based tools

Financial advisers, and even individual investors, can find many tools on the Internet to help them with their investment decisions.

But both advisers and individuals should be aware of the limitations of those tools, and be careful how they use them. Case in point: MoneyGuidePro.com has a Monte Carlo simulator on its website that, according to Zvi Bodie, professor of finance at Boston University, could lead investors astray.

However, Robert Curtis, president and chief executive officer of PIE Technologies Inc. in Richmond, Va., which developed the website, defends the simulator as a teaching tool.

how it works

A Monte Carlo simulator is used to generate random numbers for modeling purposes. For example, it is often used to generate possible annual streams of stock market returns over, say, the next 20 years, based on the historic returns of the market since 1926. The simulated return streams can be used to show the risk of investing in the stock market and the probability of investors’ achieving a desired level of wealth from their investments.

As explained by Mr. Bodie, a Monte Carlo simulation of stock market returns would work as follows: Write the return for each year since 1926 on a separate card. Put the cards into a deck and shuffle. Draw a card, and make a note of the return on it. Then put the card back into the deck. Shuffle the deck again, and draw a card again.

Continue the process until you have written down a return stream for each of the next 20 years. From that, you can calculate a compound annual rate of return for the period. Then repeat the process as many times as necessary to generate a statistically significant sample of possible return streams.

The end result shows that not only are the annual returns in the stock market volatile, but so is the expected 20-year compound annual return.

The key of the process is to return each card to the deck after the return has been noted. That, according to Mr. Bodie, is what the MoneyGuidePro simulator fails to do. MoneyGuidePro’s simulation uses 30 cards, he says. But after you click on a card and turn it over, it is not replaced.

The result: “Every time you do a 30-year simulation, you know exactly what the average compound annual return is going to be,” says Mr. Bodie. “Even though the return in any year is random, the 30-year return is not random.”

That simulation, Mr. Bodie says, is more like a 30-year zero coupon Treasury bond. “I buy it now, and I know what it’s going to be worth 30 years from now,” though the price of the bond may fluctuate randomly during those 30 years in response to interest rate changes.

Presenting stock market returns in that way is dangerous, he says. “It’s proving to people that as long as you put money [into stocks] and leave it there for 30 years, it’s safe.” That, he says, is absolutely the wrong message.

seeing volatility

Mr. Curtis disagrees.

The objective of the Monte Carlo simulator in the MoneyGuidePro website is to show volatility along the way and the impact of the sequence of returns on the ending value of a portfolio.

The simulator shows that the annual return of a portfolio can fluctuate greatly from year to year, and the portfolio still can achieve a target rate of return, and the investor should not panic over low or even negative returns some years along the way.

But another part of the model shows the impact on an investor’s retirement nest egg of the sequence of returns during the spending phase.

Negative early years hurt, and a retiree could run out of money.

The model also shows the effect of the return sequence on the final value of the investment portfolio during the accumulation phase.

In that phase, the negative returns late in the sequence hurt. Those are important insights for investors.

The key to using web-based tools is to be aware of their limitations, and use them carefully within those limitations. Advisers also must be aware of the dangers of investors’ inadvertently picking up the wrong message from models and examples.

Mike Clowes is the editorial director of InvestmentNews.