Retired Investor - Sample Output Portfolio Solution

Model Portfolio Assumptions
Functional Currency	U.S. Dollars
Target Income (Percent of Initial Savings)	7%
Target Bequest (Percent of Initial Savings)	50%
Expected Life (Years Remaining)	10
Include Equity Market Neutral?	No
Minimum Required Portfolio Internal Real Rate of Return (Note 1)	4%
Asset Allocation (Percent to Each Asset Class)
Real Return Bonds	5%
Domestic Investment Grade Bonds	35%
Foreign Currency Bonds	20%
Domestic Commercial Property	10%
Foreign Commercial Property	10%
Commodities	10%
Timber	0%
Domestic Equities	5%
Foreign Developed Market Equities	10%
Emerging Market Equities	5%
Equity Market Neutral	0%
Total	100%
Rebalancing Strategy
What is the Difference Between Actual and Target Asset Class Weights in the Portfolio that Indicates it is Time to Rebalance? (Note 2)	20%
Rebalance Most Overweight Asset Class Back to This Percentage Below Target Weight, and Most Underweight Asset Class Back to This Percentage Over Target Weight (Note 3)	5%
Expected Results (Note 4)
Expected Annual Real Return (Note 5)	6.5%
Expected Standard Deviation of Annual Real Returns	5.6%
Probability of Achieving Income Target (Notes 6, 7 and 8)	Very High
Probability of Achieving Bequest Target (Notes 6, 7 and 8)	Very High
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Note 1: The Minimum Required Portfolio Internal Real Rate of Return is the return which leaves the portfolio value just equal to zero after the bequest goal has been met. Because a model portfolio is invested in risky asset classes (whose annual returns vary), achievement of this long-term compound return goal requires expected annual returns that are higher than the goal itself. .  Note that, because individuals face different tax situations, this compound rate of return does not include the effect of taxes.  If some assets are held in taxable accounts, then this target return is the after-tax return the portfolio must earn. The required pre-tax return would be higher, and is equal to the stated return divided by (1 minus the investor’s effective tax rate).  Tax considerations are often complex, and professional advice on these issues is often useful.

Note 2: This "Trigger Percent" is the absolute percentage difference between any asset class target and its actual weight that triggers a rebalancing of the portfolio. For example, if trigger is 5%, and at least one asset class is either over or under its target weight by this amount, it is time to rebalance the portfolio. For example, if the target weight for domestic equities is 25%, and their actual portfolio weight is 32%, a trigger set at 5% (25% + 5% = 30%) would indicate the need to rebalance.

Note 3: When rebalancing, one option is to go back to target weights. Another is to try to exploit long term mean reversion in asset class returns by rebalancing the asset class currently most above its target weight to slightly below it, while rebalancing the asset class currently most below its target weight to slightly above it. To continue the example in Note 2, assuming domestic equities were the asset class currently most above their target portfolio weight, if the rebalancing adjustment factor was 5%, they would be rebalanced back to 20% (5% below their target weight of 25%). At the same time, the asset class currently most below its target weight (say, for example, foreign currency bonds), would be rebalanced to 5% above it.

Note 4: These model portfolio expected return, risk, and probabilities are based on our assumptions about for future asset class returns and risks. More information on these estimates is available on our website, www.retiredinvestor.com. Because these estimates of future asset class returns and risks are inherently and inescapably subject to uncertainty, this is also true of our estimates of the probability that this model portfolio will achieve its intended Income and Bequest Targets over its anticipated time horizon.

Note 5: When a portfolio is comprised of risky assets (that is, assets with a standard deviation greater than zero), its long term compound annual rate of return will be less than its average annual rate of return. As the standard deviation of the portfolio's expected returns increases, the difference between the two will grow larger. Note also that, because individuals face different tax situations, the stated expected annual real return does not include the effect of taxes.

Note 6: : Because of the uncertainty inherent in our modeling process (i.e., due to estimation error in the case of historical inputs; model uncertainty in the case of forward looking return estimates, the weights we use to combine our two return estimates, and the nature of the optimization process itself), we present the probability of achieving the specified income and bequest/savings targets over the specified time frame not as single probabilities, but rather using five categories to represent underlying ranges of probabilities. While our simulation optimization model in fact produces specific probability estimates, we believe that presenting them runs the risk of giving the impression (to some) that they are more precise than they really are. It is better, we believe, to err on the side of conservatism in this case. Specifically, the probability ranges that correspond to our categories are shown in the following table:

Note 7: : Obviously, the probability of not achieving the income target is equal to 1 minus the probability of achieving it. Some authors have termed this "the probability of ruin" because it signifies the probability your portfolio will decline to zero value before you die, assuming you keep automatically withdrawing the same amount each year. We have chosen not to use this terminology, as we believe people will not keep automatically withdrawing the same amount each year if they see trouble developing. Rather, most people will make some type of adjustment -- for example, increasing their part time work, decreasing the size of their bequest goal, or cutting down on their spending. Things might be less comfortable than you had planned, but you will probably still be far from "ruined."

Note 8: Before making any changes to your portfolio's current asset allocation, you should also take two additional factors into consideration. The first is the potential tax consequences. If you hold assets with unrealized capital gains in a taxable investment account, changing your asset allocation may trigger a tax liability. The size of that liability must be compared to the potential benefits of changing your asset allocation. The second factor is the current valuation of different asset classes, relative to their historical norms. While we regularly write about the difficulty of market timing, we also believe that, because they are a complex adaptive system, financial markets can and do sometimes deviate from equilibrium and fair valuation. Because of this, investors should also take current market valuation levels into account when making changes to their asset allocation.

For more information that describes some technical aspects related to the operation of the simulation optimization (SO) approach we used to determine the asset allocations used in our model portfolio solutions please go to Optimization Model: Technical Issues.