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.