Goal tracker
Why run simulations?
The future is unpredictable. Markets are volatile and future portfolio value can vary significantly, which is why it is important to consider several different return paths that your portfolio can take. Some paths will result in performance that exceeds expectations, while other paths may result in performance that disappoints. Goal Tracker uses a commonly used statistical simulation technique called Monte Carlo, to simulate a range of paths for portfolio performance, based on long-term return estimates and annual volatility around those estimates.
Goal tracker assumptions
In order to estimate the likelihood of achieving your future goals, the goal tracker tool makes certain assumptions regarding the expected risk and expected return of your investments.^{1} This paper discusses the reasoning behind those assumptions.
Portfolio risk score
At Interactive Advisors (“IA”) you may invest in a variety of portfolios that span a wide spectrum of risk. Some have lower expected risk, while others have higher expected risk. We use quantitative as well as qualitative techniques to assign a risk score to each portfolio. The risk score ranges from 1 to 5; portfolios assigned risk score of 1 typically have significant lower risk than a broad equity index like the Standard & Poors 500, portfolios assigned risk score of 2 typically have similar risk to a broad equity index, portfolios assigned risk score of 3 and higher have higher risk than broad equity index.
Initially before the launch of a portfolio on the platform and then at the beginning of every quarter thereafter, Interactive Advisors assigns each portfolio a risk score by combining:
Strategy review
Strategy review
The Investment Management team reviews for classification and adherence to previously stated objectives the portfolio managers’ description of the strategy and their answers to a questionnaire.
Risk metrics
Risk metrics
The Investment Management team analyzes quantitative measures, based on the accounts historical holding and performance. Holding characteristics, such as concentration in individual securities and sectors, leverage and margin requirements and return and risk characteristics, such as volatility, VaR, drawdowns are used.
Portfolio rules
Portfolio rules
Interactive Advisors has established and enforces a set of trading rules that determine which trades are allowed to be replicated in client accounts’ based on their appropriateness for the risk level of the portfolio. For instance, certain types of trades (like short positions or leverage) are only appropriate for certain risk scores.
While actual realized performance of portfolios within the same risk score bucket may have a wide range of outcomes, the expected risk and return of portfolios within the same risk score bucket is assumed to be the same.
IA restricts clients from investing in portfolios that are deemed too risky for a client’s risk profile (with the client risk profile determined through a risk questionnaire that each client must complete).
Risk and return estimate across portfolio types
Given the relationship between risk and returns, investing in portfolios with higher risk scores will result in a wider range of outcomes. For example, investing in risk score 5 speculative portfolios will result in a wider range of outcomes than investing in a risk score 1 cautious portfolio.
To compute expected risk and return estimates for each of the risk score buckets, we needed to look beyond the portfolios that are offered at IA. This is because most of the portfolios at IA have less than 5 years of performance history and their historical returns are thus not necessarily indicative of different market cycles.
Instead we look at a wide array of liquid ETFs that have longer histories to come up with initial estimates of expected risk and returns. Indicative ETFs considered include:
- Risk score 1: We look at broad fixed income ETFs, e.g., LQD (iShares Investment Grade Corporate Bond ETF);
- Risk score 2: We look at broad diversified index ETFs, e.g., IWB (iShares Russell 1000 ETF);
- Risk score 3: We look at broad diversified small-cap index ETFs, e.g., IWM (iShares Russell 2000 ETF);
- Risk score 4: We look at sector-concentrated ETFs, e.g., ICF (iShares Cohen & Steers REIT ETF); and
- Risk score 5: We look at geography (e.g., Emerging Markets, EM)-concentrated ETFs, e.g, ILF (iShares Latin America 40 ETF).
Table 1
Portfolio Risk score | Average of 15 year category ETF return | Average of 15 year category ETF volatility (risk) |
---|---|---|
1 | 5.2% | 6.4% |
2 | 8.3% | 14.7% |
3 | 8.6% | 18.3% |
4 | 9.3% | 20.4% |
5 | 9.4% | 23.4% |
We do an additional calculation for expected volatility, which is consistent with our proprietary risk scoring methodology.
Portfolio Risk score | Volatility range as % of S&P 500 volatility |
---|---|
1 | 0 - 60% |
2 | 60 - 110% |
3 | 110-150% |
4 | 150-200% |
5 | 200% + |
Using the upper end of the volatility range, and using a 15-year estimate of SPDR S&P 500 ETF volatility of 13.7%, we arrive at a more conservative risk estimate.
Table 2
Risk score | Average of 15 year category ETF return | Average of 15 year category ETF volatility/risk | Conservative estimate of volatility/risk |
---|---|---|---|
1 | 5.2% | 6.4% | 8.2% |
2 | 8.3% | 14.7% | 15.1% |
3 | 8.6% | 18.3% | 20.5% |
4 | 9.3% | 20.4% | 27.4% |
5 | 9.4% | 23.4% | 34.2% |
We use the numbers in green as return estimates, and the numbers in red as risk estimates for the different risk score portfolios at IA.
For our Asset Allocation (AA) recommended portfolios, we use the following risk return estimates.
Portfolio | Return | Risk |
---|---|---|
Conservative AA | 5.5% | 6.7% |
Moderate AA | 6.6% | 9.3% |
Aggressive AA | 7.8% | 13.4% |
To arrive at these hypothetical return and volatility estimates, we started off with the 10-year return and volatility estimates of the iShares Core Aggressive, Core Growth and Core Conservative ETFs^{2} at the time of writing this paper. (We selected these three ETFs because they are the benchmarks we use in managing and monitoring the performance of our Aggressive, Moderate and Conservative Asset Allocation portfolios). However, we felt that the realized Sharpe ratio for these benchmark ETFs over this 10-year period may not be sustainable going forward, since the last decade has been one of lower volatility and higher returns historically. Therefore, to account for this, we decided to adjust expected return estimates down, and expected volatility estimates up for our Goal Tracker assumptions. The adjusted lower return estimates (discussed in the previous paragraph) were sanity-checked against the return estimates for the 80/20, 50/50 and 30/70 stock/bond portfolios, calculated by Vanguard using historical data from 1926 to 2017 and with return, risk and sharpe ratio estimates of various Asset Allocation portfolios calculated by Norges Bank using data from 1961 to 2016^{3}. For the Asset Allocation portfolios, we have assumed annual commissions and management fees of 0.18% in generating the hypothetical return estimates set forth above^{4}. For portfolios belonging to each risk score bucket - the returns are exclusive of the management fee and trading costs for the representative ETFs. In order to be conservative we assume the average management fee for portfolios (other than the Asset Allocation portfolios) belonging to each risk bucket as laid out below.
Average management fee used for portfolios other than Asset Allocation portfolios by risk score
Avg. Management Fee | |
---|---|
Risk score 1 | 0.75% |
Risk score 2 | 0.46% |
Risk score 3 | 0.44% |
Risk score 4 | 0.75% |
Risk score 5 | 1.5% |
Account wide risk-return estimate
Since your investments may be distributed across multiple portfolios, we calculate risk return estimates for your overall account investments in real time.
Table 3
Portfolio type | Return | Risk |
---|---|---|
Conservative AA | 5.5% | 6.7% |
Moderate AA | 6.6% | 9.3% |
Aggressive AA | 7.8% | 13.4% |
Cash | 0% | 0% |
Risk score 1 | 4.5% | 8.2% |
Risk score 2 | 7.8% | 15.1% |
Risk score 3 | 8.2% | 20.5% |
Risk score 4 | 8.5% | 27.4% |
Risk score 5 | 8% | 34.2% |
The return estimate is simple to calculate. It is just a weighted average of the underlying return estimates across the underlying portfolio types.
The risk estimate is also just a weighted average of the underlying risk estimates across the underlying constituents, provided you assume no diversification benefits across the portfolio types. Since this represents a conservative approach in risk estimation, this is the approach we take.
Illustrative example
Portfolio | Risk score | Amount invested | Proportion (%) |
---|---|---|---|
Cash | $5,000 | 10% | |
Aggressive (Recommended Asset Allocation) | $20,000 | 40% | |
Clean Energy Portfolio | 3 | $12,500 | 25% |
Quality Portfolio | 3 | $7,500 | 15% |
Long Term Value | 4 | $ 5,000 | 10% |
Account wide calculation:
Combining the table above with table 3 below, we can calculate a weighted average.
We also allow the client to explore additional ‘what-if’ scenarios. e.g,:
a) What if the available-to-invest cash were invested in your recommended portfolio:
b) What if the entire amount were invested solely in your recommended portfolio:
Goal tracker tool
The tool displays the likelihood of meeting pre-set goals. It alerts clients that, based on inputs, the chances of meeting their goal are either ‘on-target’ (greater than 75%) or ‘manageable’ (50-75%) or ‘at-risk’ (25-50%) or ‘off-target’ (below 25%).
Caveats and disclosures
The long-term return estimates used by the Goal Tracker tool are estimates intended to provide a general guideline for the potential returns of a client’s investment with Interactive Advisors. The projections or other information generated by the long-term return estimates regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results or the realized returns of any of our portfolios, and are not guarantees of future results. Hypothetical projected portfolio returns assume reinvestment of interest and dividends and do not include taxes or inflation adjustments. Hypothetical projected portfolio values could differ significantly from the actual performance of any of our portfolios. As such your likelihood of achieving your goals portrayed by the tool may be overstated and unrealistic.
Goal tracker allows the user to set varied goals - e.g. vacation expense, medical expense, house down payment, college expense, retirement spending etc. Most of these goals require the user to just indicate a goal amount and a goal target date. For many of these goals, the goal tracker assumes a lump sum outflow on the target date. Exceptions are the college goal and retirement goal. The college expense goal assumes 4 annual payments, rather than a single payment. The retirement goal assumes monthly outflows for expenses, as well as monthly inflows for social security checks^{5}. For IRA accounts we assume no Social Security inflows and compute an approximate mandated Required Minimum Distribution^{6} based on no penalty retirement age and a linear schedule^{7}. All future inflows and outflows are adjusted for inflation. We assume an inflation rate of 3% which is consistent with the average observed inflation rate over the last 20, 40, 60, 80 and 100 years during which period inflation has fluctuated between 2 and 4%^{8}. All outflows are after-tax and assume a long-term capital gains tax of 20%. While capital gains can be taxed at 0%, 15% or 20% depending on income, we take a conservative approach and assume that the client is paying the highest rate. IRA distributions in retirement are assumed to be taxed at 25% based on a conservative estimate applicable to most clients^{9}.
The tool’s estimates and projections are hypothetical in nature, do not reflect actual investment results for your account, the account of any other Interactive Advisors client, or the realized returns of any of the portfolios, and are not guarantees of future results. There is no guarantee that you will reach your goal(s), and assumptions not used in this tool and other market developments can affect the probability of reaching your goal(s). Interactive Advisors does not make any representation that any client will or is likely to achieve results similar to these by investing in an Asset Allocation or another portfolio on its platform. The tool’s estimates and projections can vary with each use and over time. These estimates and projections are provided for informational, educational and illustrative purposes and are not intended to constitute and should not be relied on as a full financial plan, comprehensive financial planning, legal or tax advice. Interactive Advisors does not in any way represent that the estimates generated using this tool are based on or meant to replace a comprehensive evaluation of a client’s entire personal portfolio. None of the tool’s projections should be construed as an offer, recommendation or solicitation to buy or sell any security. Past performance is no guarantee of future results, and all investments, including those in any portfolios, involve the risk of loss, including loss of principal (the money you invest) and a reduction in earnings. Returns shows are net of fees and expenses. Please review the assumptions section for the fee level used to model the returns. Returns reflect the reinvestment of dividends.
- ^{1 } https://www.sdattonline.org/single-post/2018/10/12/The-Risk-and-Return-Relationship
- ^{2 } Shares Core Aggressive Allocation ETF , iShares Core Growth Allocation ETF iShares Core Conservative Allocation ETF
- ^{3 }See estimates provided by Vanguard and Norges Bank
- ^{4 }See cost calculator provided by Interactive Advisors. The 0.18% commissions and management fee level is the highest percentage level that could be charged for an investment in one of our Asset Allocation portfolios and corresponds to the lowest investment amount in one of these portfolios (i.e. $100).
- ^{5} Social security inflows are calculated based on tables and formula.
- ^{6} See IRA Required Minimum Distributions
- ^{7} See See IRA RMD worksheet
- ^{8} See inflation calculator
- ^{9} See Tax Brackets for IRA distributions