Tuesday, April 28, 2015

How Investing Can Make You Rich

Wish you could see the power of money? Wonder how the rich make their money work harder than they do?

Ever felt overwhelmed by some decision, and just picked an option so you didn't have to think about it anymore?  It can be easy to get lost in numbers. And when your head is swimming, you won't make the best decisions! 

It helps to see this kind of junk displayed in a graph. As hard as it can be to imagine how compound interest works, graphs like this can make it easy to understand!

At the Portfolio Visualizer, a website that's free (and pretty easy to use!), you can input different settings and see how they change the outcomes of different investments!

The "Backtest Portfolio" may make you cry when you see how much money you could have gotten in certain investments over the past 20 years--but it's an interesting exercise!

The Monte Carlo simulation may be more useful, as a tool to help you predict the results you can expect to see from an investment. It's obviously an estimate, not a crystal ball--but it can help answer your questions about what kind of performance a certain type of investment can bring.

Warning: nerd alert! 
This is a public service announcement: the following contains math. But it also contains details about money. So, do you hate math more than you like making money? I'll leave it up to you...

The graph above represents the results of a Monte Carlo simulation, which is a method of using existing data to generate predictions. As you may suspect, any such procedure is fraught with problems! The Monte Carlo method gets around this by taking many, many samples of the existing data--10,000, as in this case, is a typical figure for a Monte Carlo procedure.

This procedure isn't perfect (what is?), but it's a good way to get a representation of what we can expect. Unless there's some sort of seismic change in the economy, a well-done Monte Carlo procedure can form a great basis for a prediction!

The yellow line on top of the graph above represents the results if the portfolio does very well, and the red line on the bottom represents the results if the portfolio doesn't do so well. The advantage of a Monte Carlo method is that it can show you a range of possibilities, from the good to the bad, as well as the average.

The blue line shows the median, which is probably the best measure of the "average" possibility. This is the best prediction of what you can expect! Bearing in mind the key assumption that the economy will perform about the same over the next few decades as it has over the last few, there's a 50% chance that the portfolio will outperform the blue line, and a 50% chance that the portfolio will underperform the blue line.

There's obviously no guarantee that what happened in the past is the same as what will happen in the future. If the economy changes drastically, this tool won't help you. But neither will anyone else's advice--which is also based on past performance, because that's the best predictor anyone's found!

Here are the settings that yielded the graph above:
Initial amount - $10,000
Annual adjustment - No contribution/withdrawal
Simulation period (years) - 20
Simulation model - Historical returns
Bootstrap model - Single year

Asset 1 - US Stock Market - 34%
Asset 2 - REIT - 33%
Asset 3 - Long Term Bond - 33%

Median end balance (average performance) - $79,253
25th percentile end balance (relatively poor performance) - $57,050
75th percentile end balance (relatively good performance) - $109,547

What these numbers mean is that, if you were to make a $10,000 investment right now, divided among these three investment classes, and leave it untouched for 20 years--you'll likely end up with between $60k and $110k once those 20 years elapse (with a best estimate of about $80k). This is calculated using average yearly returns, selected randomly from the history of each kind of asset, and factored into the model you've set up. So you can try altering different settings, one at a time, and see what happens to the portfolio with each change. Once you get past the math, it's actually kind of like a game!

Assuming nothing changes drastically, this can provide a guide for what kind of returns you can expect from different kinds of investments. It's a good way to evaluate the strengths of different portfolios, based on past performance. And, after all, past performance--though no guarantee of future performance--is all we have to go on.

So Portfolio Visualizer can help guide you through a shot in the dark. And a shot in the dark--albeit an educated shot, in some cases--is all ANYONE can give you. So if you don't have access to a time machine, this tool is probably the best you can use. And it's a lot cheaper than paying for advice from an investment professional! [Plus, it's kinda fun, once you start poking around with the settings!]

If you want to play around with it (or if you don't think my settings are representative), here's the link to the Monte Carlo simulation on Portfolio Visualizer:

When I ran that $10,000 portfolio again, leaving it untouched for 30 years (instead of 20) with the same settings, it turns into--wait for it--a whopping $226,269 median end balance!

So, there's your easy-to-understand visualization of the results of investing. And, of course, that balance will get much bigger if you add more money to it each year!

So, how much can you turn $10,000 into? Play around with the simulator, and see if you can get better results than I did!

Happy saving!