**Encourages sound fundamental thinking
about future returns**

The Problem The Solution: TIP$TER Case Studies Sample Reports Download TIP$TER TIP$TER User Guide Support

**All inputs and
outputs are inflation-adjusted**

Most financial planners and calculators ask you to guess both what inflation and nominal returns will be for the duration of your retirement. These tools generally provide little guidance on how to guess long-term inflation and nominal return rates.

Because inflation and nominal returns have historically been extremely volatile, these are difficult – and highly speculative – inputs to guess. Moreover, the results of such simulations are highly sensitive to your speculative inputs.

TIP$TER escapes the inflation debate by
focusing throughout on *real* rates of return. After all, it is
only the *real*, inflation-adjusted purchasing power of your portfolio
– not its nominal size – that matters. By asking you to enter
expected *real*
rates of return, TIP$TER eliminates the need for speculation on expected future inflation and nominal return rates.

Advantageously, it is easier to make an educated guess about
future *real* rates of return than it is to speculate about future
inflation and nominal return rates. Historically, real TIPS return
rates have rarely strayed outside a narrow range of between
about 1% and 3% per year. Also, current real rates of return on long
terms TIPS, as long as 20 years in duration, are available on numerous
websites. This readily-available information provides a sound
(and not so speculative) basis for entering an expected real rate of return.

**Encourages**** thinking
about the expected
"equity risk premium"**

With respect to expected equity rates of return, TIP$TER's approach especially shines. A dangerous flaw of most financial simulators is that they assume that future stock returns will be just as attractive as past returns.

TIP$TER
doesn't assume, by default, that the future is going to be as good as the
past. Moreover, TIP$TER
requires that *you* specify the expected long-term return of the
market, and in a fundamentally sound way.

When thinking about equity returns, economists have long focused on the so-called "equity risk premium." The "equity risk premium" (ERP) is the difference between the expected total return on an equity index and the return on a risk-free asset. To put it another way, the ERP refers to the additional expected return for stocks – to compensate for the risk – over the so-called "risk-free" rate.

Many economists regard the ERP as the most important variable in financial economics. It is a central input of the "Capital Asset Pricing Model." Shouldn't financial planners think about the ERP when modeling their client's portfolios?

In TIP$TER, you enter your forward-looking expected ERP in the input labeled "Extra expected return on stocks." For resources on specifying this input, click here.

**Asks for annualized
– rather than arithmetic average – expected return rates **

Another subtle –
but extremely significant – difference between TIP$TER
and most other simulators is that TIP$TER
specifically asks you to specify the expected *annualized* return of
the Total Stock Market portion of your portfolio. Many financial
planners allow you to enter a *custom* expected return rate and
volatility. But these tools rarely* *specify whether they are
expecting you to enter an expected *arithmetic average* rate of
return or an expected *annualized* rate of return.
(Anecdotal evidence suggests that most expect you to enter the
expected *arithmetic average* rate of return).

It is important to understand the
distinction between an *annualized *and an *arithmetic average *
rate of return. If the stock market goes up 25%/year five out of ten
years, and goes down 10%/year the other five years, the arithmetic average
return is (5 * .25 + 5 * (-.10)) / 10 = 7.5%/year. But the *
annualized* rate of return is (1.25^5 * .9^5)^(1/10) - 1 = 6.1%/year.
Incidentally, the annualized rate of return is* *always *less than or
equal to *the arithmetic average return.

This distinction between *annualized
*and *arithmetic average *returns (sometimes referred to as
"variance drag") makes a *dramatic *difference
in predicted outcomes.* See* Prof. Peter Ponzo,
"Average vs.
Annualized Gains." A person using the ERP
formula discussed here to forecast an ERP would be forecasting an
expected *annualized* risk premium.

Most Monte Carlo
simulators won't let you enter an expected *annualized* rate of return.
If you want to do so, you will have to convert your expected
annualized return rate into an expected arithmetic average return rate all
by yourself. And generally, you won't get any guidance on how to do so.
Good luck with that!

TIP$TER, by
contrast, uses expected *annualized* return inputs.

Next: Uses transparent, realistic equity return models

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