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J&L Financial Planner's Historical Return Analysis

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Historical Return Analysis

The problem with most financial planning is they accept a return rate on each of your investments and project your financial future on those rates. The argument is over a span of years your investments will return that rate "on average." Unfortunately this is an invalid and risky assumption. Investment rates vary from year to year. Sometimes they vary greatly. We cannot accurately predict the return rate on investments or the inflation rate. Consider the following simple example

You have $1000.00 invested and you expect a 10.0% average yearly return on your investment. In two years your investment will be worth $1210.00.

Now lets assume your same $1000.00 returns -10.00% the first year and +30.00% the second. Your investments after those two years is worth only $1170.00 even though your investment returned "on average" 10.0%.

The above example demonstrates the need for a mechanism to account for the volatility of investment return rates and the variability of inflation. The J&L Financial Planner has chosen to include two alternatives, a Monte Carlo Analysis and a Historical Return Analysis, as that mechanism.

The following paragraphs outline how the Historical Return Analysis is implemented by the J&L Financial Planner.

The J&L Financial Planner allows you to create simple or complex financial scenarios (financial plans) revolving around your existing accounts consisting of investment, retirement, asset, and equity accounts. You can create and assign up to 15 asset allocation classes for each of your accounts.
A simple example would have you create three asset allocation classes Stocks, Bonds, and Cash. You would assign each account the percentage of each of its allocation classes.
A mutual fund account may consist of 70 percent Stocks and 30 percent Bonds, whereas a savings account would be 100 percent Cash. For each allocation class you assign, a historical return data file represents the returns for that class over an historical time span.
The planner comes with 6 example data files including 2 stock files, 2 bond files, 1 cash file, and an inflation file covering the years 1928 through 2013.
The files are provided as examples and should be replaced with data files which meet your needs. You can create and edit up to 15 files, each corresponding to an asset allocation class.

The Historical Return Analysis provides the following option for setting up the analysis:

  1. Do All Years -- If you check this box the analysis will start with the first year in the data files and get sequential rates from the files for each year of your scenario. It will then choose the next year in the data files and get sequential rates from the files for each year of your scenario.

    It will repeat this until the year it selects from the data files plus the length of your scenario equals the last year of data in the data files.

  2. Select Asset Class File For Template -- If you select an asset class file from the drop down list the program will use this asset class file as a template in the following manner:

    • For each year of your scenario the program will read a year from the template file and use that year as the entry point into the historical data files. You have the option of sorting the template file in ascending or descending order. For example, if you choose the ascending sort the Historical Return Analysis will start with the lowest performing year of he selected asset class template and proceed each year with a successive higher performing year.

  3. Using Custom Template Files -- You can create as many custom template files as you wish. They can be located any where on your computer system. Each template file is used as a source of entry years into the historical asset class data files.

    The years can be arranged in any order you deem necessary for your analysis. For each year of your scenario the program will read a year from the template file and use that year as the entry point into the historical data files. The program will read each year in sequential order. When the program reaches the end of the file it will start over from the beginning.

    The program saves its last entry point and will use this position as the entry the next time the Historical Return Analysis is run. It saves the entry point each time you close the program and uses the saved entry point the next time you run the financial planner.

    Each template file is a text file and has the following format. The first entry is a number which represents the number of years to follow in the file followed by the number of years. For example, if you want a file which contains 100 years the file might look as such:
    100
    1928
    1934
    1960
    1943
    and so on for the next 96 entries.

    The program uses the template file name as the identification of the analysis (title) when you run the Historical Return Analysis. You should use a file name for each which represents the emphasis you placed on the analysis.

NOTE: Each time you uncheck the custom template box and then re-check it the program will prompt you for a new template.

Summary

In summary, the Historical Return Analysis is able to estimate the probability of achieving the success of your scenario by accounting for the yearly variability in the two main factors contributing to it's outcome, the return rate on your investments and the inflation rate. You can execute up to a thousand trials of your scenario. Each trial is a fully independent execution of your financial plan, where each year the return rate on your investments and the inflation rate can take on a range of values based on historical asset class return data.

The large number of trials allows the analysis to compute the statistical probability your financial plan will be successful. For example, if after 1000 trials, 750 of those trials achieved your financial goals, your financial plan success rate is 75.0%.

If your financial plan success rate is below your expectations the J&L Financial Planner allows you to make easy scenario changes to play "what-if" with your financial future.

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