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Monitor the Money – Not the Returns

Dr. David Edward Marcinko MBA CMP™

http://www.CertifiedMedicalPlanner.org

[Publisher-in-Chief]

While taking my certified financial planner courses to earn the CFP® designation, almost two decades ago at Oglethorpe University in Atlanta, I learned that in classic retirement planning engagements the financial planner or advisor determines the client’s retirement income needs, the assets already earmarked for the retirement portfolio, the desired retirement date, how distributions will need to be made, the assumed inflation rate, and life expectancy, etc.

Then, if a shortage develops, the advisor changes the asset allocation, increases the savings rate, proposes postponing retirement, or suggests reducing retirement income expectations, etc.

However, later in business school I learned that even when the inflation rate and investment returns prove to be accurate; this approach often fails doctors and all investors.

Geometry not Arithmetic

Why? Most planners focus on the wrong thing when monitoring portfolios. Possibly, there is confusion between compounding investment returns and compounding wealth. Planners tend to compound the arithmetical average return in projecting ending wealth over multi-period horizons. But, the accumulation of wealth is determined by the geometric compounding of actual returns.

Law of Large [Small]  Numbers

Still later on in B-school, I learned of the LoLN [normal distributions, parametric equations and cohorts], as well as Poisson distributions [non-normal or asymmetric distributions, and non-parametric equations and cohorts] or Law of Small Numbers.

Planners and Advisors often believe in the former Law of Large Numbers, and eschew [or are unaware of] the later — that is, that over time, average annual returns will approach ever more closely the expected return. The longer the investment horizon, the further the portfolio can wander from its expected dollar value despite the fact that it is approaching its expected return. The future value of each portfolio is determined by the unique and unpredictable pattern of compounded returns and inflation it suffers.

IOW: The longer the period over which this pattern can exercise its effects, the greater the potential divergence from its required return. In fact, while the expected range for the annualized rate of return narrows over time, the expected range for the terminal value of the portfolio diverges over time.

Assessment

Today, forward thinking advisors use “portfolio sufficiency monitoring” to adjust nominal performance results for inflation by establishing benchmarks for performance objectives, setting triggers for reevaluation of the portfolio when it wanders too far from established benchmarks, and monitoring and adjusting portfolio risk to maximize the probability of meeting retirement portfolio objectives.

It answers the question: “Will I have sufficient assets to meet my retirement income needs?” while investment performance monitoring answers the question, “Is my retirement portfolio performing well relative to other portfolios?” My doctor clients retire; not others!

Note: Monitoring Retirement Portfolio Sufficiency,” by Patrick J.Collins, Kristor J. Lawson, and Jon C. Chambers, Journal of Financial Planning, February 1997, pp. 66–74, Institute of Certified Financial Planners.

Conclusion

And so, your thoughts and comments on this ME-P are appreciated. How do you monitor your portfolio? And, how do FAs perform same for their physician and other clients. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

Practice Management: http://www.springerpub.com/product/9780826105752

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Filed under: CMP Program, Financial Planning, Investing, Portfolio Management, Retirement and Benefits | Tagged: CMP, Investing, Law of Large Numbers, normal distributions, Poisson distributions, Portfolio Management, retirement planning, www.certifiedmedicalplanner.com | 4 Comments »