Don’t panic, I’m not going to get into too much math here.  But it is very important to understand that all of personal finance is about making projections, which are far from certain.  I will repeatedly emphasize that no one has a good crystal ball on exactly what the future holds, but we can use the past and a little probability to help us determine our chances.  For example, would you retire if you had a 80% chance of outliving your assets?  50% chance?  10% chance?  near zero?  That answer is different for everyone, but no one can make that decision without getting an estimate of those probabilities, here is an approach you can use.

Although I don’t believe anyone can precisely tell you what will happen tomorrow or next month or next year, it is reasonable to look at stock and bond price histories for any given time period, going back 100 years if you want, to make estimates of the general trend of those assets.    Let’s look at the past 10 years, the longer term numbers actually aren’t too different.  The average return of the S&P 500 (which we’ll use as our metric for stocks) is 10.4%, with a standard deviation of 18.3.  For the Vanguard Total Bond fund (which we’ll use as the metric for bonds) the average is 4.0% with a standard deviation of 2.8.  Don’t worry if you skipped that lesson on standard deviation in math class, just understand that a big number relative to the average means that the return fluctuates a lot year to year, and a small number less so.  We can then use something called Monte Carlo analysis which is a complicated term for a simple concept, run a whole bunch of sample “futures” and see how they all turn out.  Think of it like throwing dice 1000s of times and recording what numbers you get.  You can make some inferences on those future possibilities based on the results.

Using a little magic in Excel with random number generation for the return on a given year, and the means and standard deviations above, we can see what is the probability of getting to our retirement goal.  Recall in an earlier post we showed we would get to our retirement savings goal of $1.2M.  Hurray!  Guaranteed? Uh, no.  Crud.  Going back to our 30 year old with $50k in her 401k, using our asset allocation, adjusting each year, and diligently saving, the chances of having at least $1.2M in the account at retirement? 78%.  Good, but maybe you don’t want to bet your whole livelihood on it.  Before getting completely bummed, the chance of at least $2.0M?  38%.  Not bad, probability works both ways!  Also, remember you aren’t doing this in the dark!  If things happen to not be working out the way you planned, you can adjust.  Maybe your house is a little smaller, or you work another year, or find cheaper hobbies; you have the ability to live to your means, no matter what the future holds.

If you are a weirdo like me and interested in the gory details of the excel calculations, here is a link.  It’s really not that bad!