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J&L Financial Planner's Historical Return Analysis

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Historical Return Analysis

Figure 1.0 - Historical Return Analysis

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.

J&L Financial Planner's Historical Return Analysis

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 10 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 representing 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 2003. The files are provided as examples and should be replaced with data files which meet your needs. You can create and edit up to 10 files, each corresponding to an asset allocation class.

The planner gives you two options with the Historical Return Analysis.

The first allows you to execute your financial plan over the historical time span. This generates your net worth for each year of your plan based on the returns of the historical data starting with the first year of the data. In the provided files this would generate a net worth (a line graph) starting with the returns from 1928. Next it would generate a net worth (another line graph) starting with the returns from 1929. It would do this for each year of your financial plan.

The second and default analysis chooses a year of data from the historical data files for each year of your scenario by the following methodology. It creates 4 groups (g) of sequential historical data years based on the number of years provided in the files. It creates a list of the 24 possible combinations these groups can be arranged. For example g1, g2, g3, g4 followed by g1, g3, g2, g4 followed by g1, g2, g4, g3 and so on for all of the possible combinations. For each age in your scenario trial an entry into the historical data files is selected starting with the first group and sequencing though the years in that group followed by the next group in the list. If the list is exhausted the program will start again, but from the 2nd group in the list.

The second analysis also allows you to choose the number of sequential years the program will use starting at the current age in your scenario and the current entry into the historical data files. For example, if the current entry into the files is 1931 and you have chosen 3 sequential years the program will execute the current age of your scenario with data from 1931, the next age with data from year 1932, and the next with data from 1933 before choosing the next entry into the files.

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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