What are the chances that in the future the data needed in generating a new portfolio could be provided somehow instead of trying to come up with return, betas, etc.. yourself.
I primarily use Vangaurd funds to construct my portfolios, It seems like various mutual funds data could be available some how.
Any future plans?
Thanks, Steve
Disclaimer: ESPlannerBASIC, ESPlanner, ESPlannerPLUS and ESPlannerPRO, are educational calculators designed to give users input in mapping out financial futures, but should not be acted upon as a complete financial plan. The creators of these programs are not certified, registered, authorized, or any other type of financial planners. These programs are simply tools for helping you think through economic futures. Its "recommendations" should be viewed as informative inputs into your own decision-making with respect to saving and the purchase of life insurance. ESPlannerBASIC, ESPlanner, ESPlannerPLUS and ESPlannerPRO provide neither economic, financial nor tax advice, which can only be delivered to you by authorized professionals.
RSS
We've looked into this a number of times, thus far without any resolution one way or the other.
Best,
Dick Munroe
Steve:
Yes, this is quite a bit of complex information that is required. This FAQ includes a recent explanation:
http://www.esplanner.com/faq-how-do-i-create-custom-assets-monte-carlo
I suspect that in some future version of the program this might be simplified by using data that for end users to determine.
Dan
it will be nice if there's an import function from Esplanner from excel or text files. The Esplanner community could also help to update a common set of fund/ETF prices with data.
I have a question regarding the article provided by Dan at this link. It says to divide the (real return +1) by (inflation rate +1). I have created a bunch of new assets using this procedure recently and the instructions I found said to subtract inflation from the real return. That make more sense to me; I reduce my return by the reduction in purchasing power.
http://www.esplanner.com/faq-how-do-i-create-custom-assets-monte-carlo
Could some one explain why it is correct to divide rather than to subtract?
Thank you.
Larry:
Would you please go through that FAQ and make sure the math is correct? Let's include a math example like Dick does below. Let's use a standard deviation from a fund etc. and display the math.
The subtract was incorrect wherever you discovered it.
The basic issue is timing and when inflation happens. Say you have 100K in real assets (today's dollars) with a 6% real rate of return and an inflation rate of 3%. How many nominal dollars next year do you need to have the same purchasing power as that 100K plus the real interest earned on it?
Ok, how many real dollars do you have at the "end" of this year:
100K * 1.06 = 106K
And how many nominal dollars do you need in next years money to give you 106K in purchasing power:
106K * 1.03 = 109,180
In both of these cases, we're really writing an expression of the form:
100K + 100K * .06 = 100K * ( 1 + .06 ) = 100K * 1.06
Which is where the 1+ things come from.
So the nominal rate of return is:
1.06 * 1.03 = 1.0918
And to figure out real dollars, you divide by inflation (more particularly, by the CPI) to figure out the number of today's dollars from future dollars.
Hope this helps.
Best,
Dick Munroe
Thank you both for your help with my question. I was surprised to see so much action on Sunday to a question posted on Saturday night.
It seems to me that my issue may be semantics rather than mathematics. The nominal return for a year, as I have read it, refers to the uncorrected value of (PRICE boy-PRICE eoy) divided by PRICE boy, where boy is short for beginning of year and eoy means end of year. Looked at from this perspective, I think that the real return is that value less the inflation rate. Adding the "1" has seemed to me a convention for the variance calculation.
I agree that Dick's calculation is the one that matters to help make sure that I do not outlive my money. Is nominal return the correct term for the result?
What all this tells me is that for all that I tried to understand these calculations over the holiday, I may not yet have the conceptual framework nailed down. For this reason, I appreciate Dan's request. If I can conceptually grasp the reasons why we calculate these important factors in the manner that we do, I can extend that framework to other financial calculations when I encounter them.
I found a mistake in my original post. I said that "the instructions I found said to subtract inflation from the real return." I meant to write that to obtain real return, the instructions said to subtract inflation from the nominal return for that year.
Maybe an example will help. Your bank account give you interest. This is a nominal interest in that if your bank gives you 6% and you have 100K in the bank, at the end of the year you have $106K in your bank account. But due to inflation what you can buy with that $106K isn't the same, so to convert to today's dollars, you have to divide by the CPI (inflation rate if we're only looking at one year). So with a 3% inflation, you divide by 1.03 to get the value of dollars today ($102...). The 1 + rate or 1 + inflation is necessary to get the math to work out right.
Next year, your bank still gives you 6%, but if inflation next year goes up (or down) the purchasing power of the dollars is smaller or larger:
( 100K * 1.06 * 1.06 ) / ( 1.03 * 1.xx )
where xx is the inflation rate for next year and so on. The 1.06 is a standard compound interest rate, the 1.03 is a standard compound inflation rate. As mentioned above it's because compound interest calculations just add the interest to the corpus so you get 1 + rate * corpus at the end of the year. Beginning of year, ending of year don't really enter in except in terms of accrued interest. It's probably easier to think of the $100k as the assets available at the end of the previous year (same as the beginning of the current year), then the multiplication converts end of period assets from one year to the next.
Best,
Dick Munroe
Thanks, Dick. I have to pursue this further. This is not a trivial question for me. I created 15 new asset classes over the holiday and do not want to go back and recalculate and recreate assets unless I am sure that I made a mistake. I am not yet sure.
I am familiar with discounting cash flows to arrive at a present value of an investment. Your description follows that model. I am just not sure that this is what is used for monte carlo analysis.
Here are some definitions of these returns that I found on the web:
nominal return
"The rate of return on an investment without adjustment for inflation. While nominal return is useful in comparing the returns from different investments, it can be a very misleading indication of true investor earnings on an investment."
real return
"The inflation-adjusted rate of return on an investment. If an investor earns a return of 12% during a year when inflation is 4%, the real return is 8%."
David Darst in "The Art of Asset Allocation" writes: "to covert nominal returns into real returns, investors must subtract the rate of price inflation from the nominal rate of return...." (p 260)
ESPlanner's new asset dialog box asks for calculations to be performed on the real return. I calculated the real return consistently with these definitions. If the calculation required by ESPlanner involves dividing the nominal return be the real return, the dialog box is asking for something other than the real return.
Can you please get confirmation as to whether the Monte Carlo's calculations require calculations to be performed on the real return as defined or the compound calculation that you have explained.
That's actually incorrect for 12%/4%. The real rate of return is 7.6923...%, not 8%. Many authors assume you wouldn't understand the division issue and so don't try to explain it. It's simple, you get real returns, you get inflation, it's a compound interest (corpus * (1 + real) * (1 + inflation)) problem, so nominal to real is a division and real to nominal is a multiplication, not subtraction and addition. FWIW many economists and investment folks get this wrong when they talk about it as well, as you can see from the quote from Darst's book. The subtraction IS an approximation to the real rate of return, but it isn't the real rate of return and subtracting will lead you to consistently OVER-ESTIMATING your real rate of return, not good especially if you're working with a 20 or 30 year horizon.
If you're getting 6% nominal interest on an asset:
(1 + real) * (1 + inflation) = (1 + nominal)
(1 + real) * (1 + inflation) = 1.06
(1 + real) = 1.06 / (1 + inflation)
real = (1.06 / (1 + inflation) ) - 1
QED.
If you plug .12 in for nominal and .04 in for inflation into the above equation, you'll see why I said 8% is wrong.
Best,
Dick Munroe
Thanks, Dick. I guess I have to recalculate and rebuild asset classes and rerun the scenarios that I like. I have now heard from several sources that I am mistaken and that you are right. Fortunately, once I rework the portfolios, the rest of it will be pretty painless, since ESPlanner will do that work.
Thanks for your patient explanations.
Tag
One caveat in all this, the calculations I show deal with discrete, fairly large time intervals (year, month, day). In discussions with Larry, he tells me that as the intervals get progressively shorter, the nominal to real calculation approaches subtraction as a limit (I'll have to look at the math details to see if I can figure out why at some point). For any useful period of time though, the above is correct.
Best,
Dick Munroe
I am glad that you mentioned the issue of periods shorter than a year. Some of the asset classes that I built had to be for very short times. I invest in ETFs, some of which have been in place for less than 2 years. Since I do not have access to the price history for the underlying indeces, my approach has been to get weekly returns, convert them to real returns, annualize them, and then conduct the calculations. We have already covered the real return calculation. I need to be sure that I annualize the data correctly.
From our discussion, I assume that I calculate as follows: (period return) raised to the 52nd power, minus 1. Is that correct?
Just as I read that it is proper to subtract inflation from the nominal return to obtain the real return, I have read formulas on the web that suggest multiplying the weekly return by 52 instead of raising it by the 52nd power.
Some ETFs have existed for a longer time and I obtained monthly returns for them. I would substitute 12 for those calculations in place of 52 as described above.
For all of these cases, I calculate the ETF "SPY" in the same manner and for the same period in order to obtain the variance to the S&P 500.
How many data points are enough, anyway?
If you and Larry do write examples for us to follow, please add advice on how to handle this kind of issue also. It would also be handy if you could add a hyperlink to the article right by the New Asset button. I went to this extra effort because I did not find the existing article at your site. Since this is such a critical calculation, it would help to treat the instructions in a more special way than the other articles on the site.
I look forward to receiving your advice on annualizing data as I hope to complete the work this weekend.
Regards, Tag Van Winkle