At Aspire, the conversation is spoken in terms of your financial plan’s success. After all, you being able to confidently achieve your goals is the only measure of financial success that matters. Throughout these conversations, we reference your plan’s confidence and the confidence zone. Let’s dive a little deeper into this idea.
What is the Confidence Zone?
The confidence zone is essentially a calculated range in which your portfolio values can drift while still being able to support the goals in your financial plan. The confidence zone is determined through a combination of your assets and allocation, your goals and cash flows, and 1,000 market simulations.
These 1,000 market simulations are run using a statistical method called Monte Carlo. The portfolio’s extensive history of risk, return, and correlation are incorporated into each trial to create a single potential market lifetime. Each of the trials is then ranked according to the ending dollar amount and given a corresponding percentage. For example, the 850th trial yields an ending wealth greater than 149 of the 1,000 iterations.
We use a range of 75% to 90% to define our confidence zone. This represents the broad spectrum of potential market results in which your financial plan can be successful. Confidence exceeding 90% means your financial plan is resilient to the most extreme of simulated market lifetimes, many of which have never happened. In essence, you are making sacrifices today to protect yourself from a market unlikely to happen in the future. Falling below 75% means your financial plan would not accomplish its goals in three out of four market lifetimes. Your financial plan may not be resilient enough to experience market performance significantly below historical averages over the long-term.
What can lead to falling outside of the Confidence Zone?
Falling outside of the confidence zone is something that is supposed to happen throughout the life of the plan. We expect our client’s plans to change, as financial lives unavoidably do. In addition, we don’t expect the market to behave in a pre-destined way.
Changes to Your Plan – Shift in Confidence
Changing your plan’s goals or planned future savings will result in a shift of your confidence zone. Early in the plan life, deviations from the confidence zone are more likely to be attributable to plan adjustments or changes. An increase in your goals or a decrease in your savings will result in the confidence zone shifting up, thus decreasing your current confidence (Figure 3). The opposite holds true for decreasing your goals or increasing your future savings and the corresponding increase of your current confidence (Figure 4).
Market Movement – Pivot in Confidence
Market behavior, as contradictory as it sounds, is both unknowable and inevitable. It is important to understand, however, that your plan is not dependent on the market behaving a specific way. Rather, we use the confidence zone to facilitate making plan adjustments, whether through your allocation or your plan’s goals.
As the market depreciates, your confidence decreases. This would prompt the opportunity to buy equity at a low price or to decrease goals.
As the market appreciates, your confidence increases. This prompts the opportunity to sell equity at a high price or to increase goals.
What decisions can be made to get back in to the Confidence Zone?
Falling outside of the confidence zone is nearly certain, so it is important to be prepared to make these decisions before they happen. Being proactive requires defining goal priorities and being objective regarding potential portfolio allocation changes. In a calm state, you may be willing to move to an 80% equity portfolio. However, this decision can change considerably when faced with the emotional reactions tied to market movements. (When the market is down and the pundits are yelling “SELL SELL SELL”, it is hard not to be influenced.)
By using the confidence zone to facilitate decision making, we rely on the plan success to be the main driver of allocation considerations. This is an objective, non-emotional process and is not subject to the human biases and heuristics that can handicap portfolio performance.
Above 90% - Your plan can afford to take less risk, increase goals, or save less.
Between 75% and 90% - Small market movements have no impact on my plan’s confidence.
Below 75% - Your plan requires more return, decreasing your goals, or more savings.
This process enables you to make decisions based on what you are trying to achieve, using tools to utilize the market instead of relying on its erratic behavior to determine your success. Quickly, you realize that short-term market behavior rarely impacts the long-term success of your financial plan.
Do I need to take this much risk? What can my assets achieve in terms of my future goals? Do I need to make a decision based on this market movement? You can use your plan’s confidence to be prepared to make these decisions.