Beyond the Average

A plan built on one expected return can fail even when the average turns out to be exactly right. Thinking in distributions changes the question we ask.

Most financial plans begin with a single number: an expected return. Assume 4.5 percent above inflation, carry the arithmetic forward thirty years, and a spreadsheet will draw a smooth and reassuring line. The difficulty is that no investor has ever lived on a smooth line. We live through one particular sequence of years, in one particular order, and we only get to live it once.

This article explains a technique that operations researchers, engineers, and actuaries have used for decades to deal with that problem: simulation. It is not exotic, and it does not require a doctoral degree. It requires a change in the question, from what will happen? to what could happen, and how often?