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Using Investment Simulations To Help Manage Risk
The Limitations of Solely Using Historical DataThe historical analysis used in the development of the CCM Multiple Asset Class Approach to investing is very relevant since it draws on asset class correlations and investment performance over a 37 year period (19702006). However, it is also limited since we know the future will be different from the past. For example:
The CCM Investment SimulatorThe CCM Investment Simulator is a detailed investment allocation simulator which helps us better understand the realistic range of possible future outcomes, both favorable and unfavorable, for a particular asset allocation. The model simulates the future using over 75,000 historical records of returns, inflation, and taxes dating back 37 years (19702006).Monte Carlo simulation is a method that estimates possible outcomes from a set of random variables by simulating a process a large number of times and observing the outcomes. In our case, the Monte Carlo simulator is a computerized technique, which is the basis for probabilistic risk analysis, which replicates real life occurrences by mathematically modeling projected events, such as investment cycles, annual returns, and annual inflation rates. Monte Carlo simulation uses predefined probability distributions of risk variables to perform random modeling over many simulations.
The CCM Simulator allows the investor to examine multiple future investment paths based on varied market conditions, annual rates of return, and inflation. A conventional financial projection, which might assume annual fixed inflation of 4% and fixed annual growth of 10%, cannot take into account the variability that occurs in the real world. Simulator  Basic Input and AssumptionsHistorical data was collected for our investments/asset classes (or meaningful proxies) from 1970 to 2006 (37 years). The period 19702006 was selected since it includes several different investment climates. Prior to running simulations, the investor's current portfolio size, net future deposits, and anticipated withdrawals are entered, along with an asset allocation. The basic logic of the CCM Investment Simulator is outlined below:
The model simulates annual returns and inflation rates for up to 65 years. It can also take into account other important factors such as taxes, withdrawals, and the effect of inflation on your purchasing power. In an effort to capture more realistic volatility in the simulator, 12month rolling returns are used as input for both the S&P 500 and the CCM Base Allocation from 19952006. Annual returns are used in both cases from 19701994. This causes a slight variance in historical annual returns and standard deviations for both the S&P 500 and CCM Base Allocation when compared to calculations based solely on annual returns. Using 12month rolling returns allows us to capture intrayear volatility that may not show up in an annual return.
Using the CCM Simulator to Assess RiskReward ProfilesGraphs 3 and 4 show the results of 100 simulations for both the CCM Base Allocation and the S&P 500 Index (a 100% stock portfolio). While the simulator runs for 65 years, only the first 10 years are shown to make it easier to discern the differences in the uncertainty between the outcomes. The top of page (Graph 3) shows the S&P 500 Index and bottom (Graph 4) shows the CCM Current Base Allocation. More conservative investors have a lower risk allocation and more aggressive investors have a more aggressive allocation than the allocation used in this example.Graph 3
Graph 4
Some comments about Graphs 3 and 4  Simulation Results:
Simulating RealWorld vs. Published InflationSince inflation is a significant longterm concern, the model can be set to simulate true inflation rates rather than published inflation rates. True inflation rates refer to what consumers actually experience in the checkout line. The model uses actual published inflation rates from 19701982 and adjusted historical inflation figures based on changes made to the CPI since 1982 (19832006). The adjusted figures are based on research by John Williams of Shadow Government Statistics. The U.S. government published an average inflation rate of 3.07% between 1983 and 2006. Over the same period, Williams' research concluded the real figures produce an average inflation rate of roughly 7.03%. Similarly, between 1970 and 2006, his research concluded the average inflation rate was roughly 7.24% vs. the published average of 4.68%. You can learn more using the links below:
Risks and Limitations to the CCM ApproachWhile the CCM approach to investing can reduce risk from a historical and simulated perspective, it can by no means eliminate risk. Examining historical returns and simulating future returns is beneficial, but both rely on historical correlations between asset classes which change over time. Several factors have contributed to an environment where stocks, bonds, and commodities have all performed well from 20032007. This is an unusual situation which points toward changing correlations between asset class price movements. As a result, the risks in the current market are most likely higher than the historical data suggests. As asset managers, we must be prepared to adjust to an ever changing investment landscape. Obviously, investing in the asset markets will be difficult going forward for all participants, including those who utilize the CCM Multiple Asset Class Approach and models. However, the concepts presented here should help investors improve their odds of protecting and growing their assets on an inflationadjusted basis. All market based investment portfolios are subject to principal loss, including a multiple asset class portfolio.The next segment will discuss how we rebalance asset allocations from time to time based on changing market conditions.
Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com All material presented herein is believed to be reliable but we cannot attest to its accuracy. The information contained herein (including historical prices or values) has been obtained from sources that Ciovacco Capital Management (CCM) considers to be reliable; however, CCM makes any representation as to, or accepts any responsibility or liability for, the accuracy or completeness of the information contained herein or any decision made or action taken by you or any third party in reliance upon the data. Some results are derived using historical estimations from available data. Investment recommendations may change and readers are urged to check with tax advisors before making any investment decisions. Opinions expressed in these reports may change without prior notice. This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. The investments discussed or recommended in this report may be unsuitable for investors depending on their specific investment objectives and financial position. Past performance is not necessarily a guide to future performance. The price or value of the investments to which this report relates, either directly or indirectly, may fall or rise against the interest of investors. All prices and yields contained in this report are subject to change without notice. This information is based on hypothetical assumptions and is intended for illustrative purposes only. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
