Investment portfolios are often categorized as "conservative," "moderate," or "aggressive" depending on the percentage of the portfolio that is invested in stocks. For example, a portfolio in which only 30-40% is invested in stocks, with the remainder invested in bonds, would be considered "conservative." On the other hand, a portfolio invested 80-100% in stocks would be considered "aggressive."
It is generally assumed that the more aggressive one's portfolio, the greater the potential reward. Along with the potential for great reward comes great risk: the potential for great loss.
But it is hard for most investors to assess whether a conservative or aggressive portfolio is best for them. Investors are frequently told that they should make the decision on the basis of their need (e.g., investors who need a high return to achieve their goals should invest more aggressively), their age (e.g., an investor should invest their age in bonds), or their risk tolerance (e.g., an investor should invest no more than 2X one's maximum tolerable loss). These simple rules of thumb – although useful – give investors no realistic grasp of just how risky or how rewarding a given asset allocation could be.
To make an informed asset allocation decision, sophisticated investors want some grasp of both the potential risk and the potential reward associated with a given stock allocation. Arguably the best way to give an investor that grasp is to display either a distribution, or a spectrum of percentile outcomes, of projected or simulated outcomes.
This is precisely what TIP$TER is designed to do. TIP$TER assumes that the investor will divide their portfolio between a stable risk-free basket of assets (e.g., TIPS) and a volatile but higher-returning basket of risky assets (e.g., a total stock market index). In TIP$TER's user interface, investors enter their return expectations, their savings and retirement budget plans, and their asset allocation policy.
TIP$TER simulates the stock portion of the investor's portfolio against over 1600 intervals of a looped and mean-adjusted data set of S&P 500 real return data (spanning 1871 through 2011) that has been scaled to match the investor's own specified forward looking expected annualized real return. TIP$TER assumes that the balance of each portfolio is invested in an approximately risk-free asset, such as TIPS, that yields the inflation-adjusted return specified in the "Your Return Expectations" section. TIP$TER also assumes that the portfolio is rebalanced once a year and that its earnings and dividends are reinvested, with no realized taxes until distributions are taken from the portfolio.
After simulating a portfolio, TIP$TER displays two charts.
The second chart (an example of which – based on the same inputs – is illustrated below) reports the simulated portfolio balance, over time, for the 5, 50, and 95 percentile outcomes of the simulation.
By selecting the "Choose Percentile" checkbox, an investor can explore other percentile outcomes – from 0% to 100% in 5% increments – of the simulation. If the investor specified a variable asset allocation policy (e.g., one that increased the stock allocation after simulated bear markets), the investor can also explore how the simulated asset allocation changed over time for the selected percentile outcome.
TIP$TER also displays several summary statistics from the simulation, including: the investor's shortfall risk, the life-weighted average retirement budget supported by the simulation, and the "average" final estate size.
TIP$TER's Asset Allocation Risk/Reward Spectrum Chart
One of TIP$TER's most powerful, patent-pending features is its Asset Allocation Risk/Reward Spectrum chart, which plots the distribution of the simulated percentile outcomes for a range of different asset allocations on a common chart.
To enable the chart, TIP$TER's interface provides "Click to test a range of asset allocations" button, depicted below.
When that button is selected, TIP$TER displays a chart like that one depicted below.
When the "Simulate Different Asset Allocations" button in the right-hand corner is selected, TIP$TER simulates eleven different portfolios, ranging from a 0% allocation to stocks to a 100% allocation to stocks, based on the user's inputs. TIP$TER assumes that the balance of each portfolio is invested in a risk-free asset, such as TIPS, that yields the inflation-adjusted return specified in the "Your Return Expectations" section. TIP$TER then simulates the stock portion of the user's portfolio against a mean-adjusted set of S&P 500 real return data from 1871 through 2011.
After all the simulations are complete, TIP$TER's Asset Allocation Risk/Reward Spectrum chart illustrates the distribution of percentile outcomes for each simulation. TIP$TER displays each outcome in terms of the life-weighted average retirement budget supported by a given percentile outcome (ranging between 0% and 100%) of the simulation.
Asset Allocation Case Studies
The links to the left illustrate how sensitive the spectrum of asset-allocation-related risks and rewards are sensitive to different inputs, including the user-specified equity-risk premium (i.e., "extra return on stocks"), the planned duration of the portfolio, and the investor's planned spending and investing behaviors.