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The Benefits of Choosing a Stochastic Model

Author: Adam Robins
25 February, 2020

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Unless you are lucky enough to own a crystal ball, the science (or art) of predicting future economic events can be complicated. Without a model that is both robust and flexible, the task of forecasting market behaviour in an ever-changing world can be tough.

The challenge for the majority of financial services companies, especially when it comes to retirement planning, is the ability to provide realistic forecasting that enables consumers to make better-informed choices about their future finances.

Traditionally, most financial planners have used deterministic models to project future investment returns. Although deterministic models have the benefit of simplicity, they rely on single assumptions about long-term average returns and inflation.

In reality, such outcomes, in particular when it comes to income drawdown, can be easily upset by the unexpected implications of sequencing risk, with no allowance for the fact that markets are complex, irregular and ever-changing. All of which renders deterministic models inadequate and potentially misleading.

Forecasting for different outcomes

Being able to forecast potential outcomes for individuals entering the decumulation phase, specifically, income drawdown is vital and will require a different approach to that used for individuals investing for accumulation. 

There are two main reasons for this:

  • The objective for drawdown is different – retirees will need a sustainable income during retirement compared to the accumulation of wealth
  • The measure of risk is consequently different – variability of income as opposed to volatility in accumulation outcomes

When entering drawdown, you will need to seek a return better than bonds to overcome mortality drag. While a high-return is required to overcome the negative effect of mortality drag, the high-volatility associated with a substantial equity weighting leads to a more rapid depletion of the capital supporting regular fixed income withdrawal.

The following factors also need to be considered: 

  • The amount of income that is needed
  • The length of time for which the income needed (life expectancy reduced by less than a year for each year survived which means that income required for a more extended period than initially anticipated)
  • The volatility of investment markets

If a retirement planning tool is unable to take into consideration the above factors or model the effect of any market downturn in the early years of income withdrawal, the tool is unsuitable. If the technology you use cannot show you a range of possible outcomes from which you can effectively plan, then it’s not a useful planning tool.

Benefits of a stochastic model

The advantage of using a stochastic model is that it can reflect real-world economic scenarios that provide a range of possible outcomes that an investor may experience and the relative likelihood of each, particularly when in the decumulation phase.

By running thousands of calculations, using many different estimates of future economic conditions, stochastic models predict a range of possible future investment results showing the potential upside and downsides of each.

By avoiding any significant shortfalls inherent in deterministic models, stochastic models provide realistic, robust forecasts that demonstrate the suitability and enable consumers to make well informed and sensible investment choices, which directly impact on their future wealth prospects and lifestyle.

Now we know that future returns are unknown at the beginning of an investors journey. Yet, deterministic models assume investment returns will be the same every year, ignoring inherent randomness in the markets, giving consumers the impression of certainty, where none exists.

One way to help consumers see prospective outcomes in terms of the probability of successfully meeting their financial objectives is through a range of engaging charts and graphics, helping crystallise their capacity for loss.

Providing information in this way enables stochastic models to offer more significant potential than deterministic forecasts for analysing risk and allowing the investors to make informed decisions.

What next?

We provide an outline of the various types of forecasting models here. A complete, real-time picture of all the potential outcomes makes all the difference to realistic outcome planning. And that’s the difference between a deterministic model and a stochastic model. 

Find out more about stochastic forecasting and why we believe it’s the most credible model by reading our eBook, Modelling Future Outcomes. Why Stochastic is the Credible Choice?

Modelling future outcomes. Why stochastic is the credible choice