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Life Cycle Goal Achievement or Portfolio Volatility Reduction?

34 Pages Posted: 29 Mar 2015 Last revised: 8 Oct 2015

M. A. H. Dempster

University of Cambridge - Centre for Financial Research; Cambridge Systems Associates Limited

Dwayne Kloppers

Alexander Forbes Financial Services (Pty) Ltd

Igor Osmolovskiy

Cambridge Systems Associates Limited

Elena Medova

University of Cambridge - Centre for Financial Research; Cambridge Systems Associates Limited

Philipp Ustinov

Cambridge Systems Associates Limited

Date Written: March 30, 2015

Abstract

This paper is concerned with the use of currently available technology to provide individuals, financial advisors and pension fund financial planners with detailed prospective financial plans tailored to an individual's financial goals and obligations. By taking account of all prospective cash flows of an individual, including servicing current liabilities, and simultaneously optimizing prospective spending, saving, asset allocation, tax, insurance, etc. using dynamic stochastic optimization, the paper addresses the question of the title by comparing the results of such a goal-based fully dynamic strategy with representative current best practices of the financial advisory industry. These include piecemeal fixed allocation portfolios for specific goals, target-date retirement funds and fixed real income post-retirement financial products, all using Markowitz mean variance optimization based on the very general goal of minimizing portfolio volatility for a specific portfolio expected return over a finite horizon. Making use of the same data and market calibrated Monte Carlo stochastic simulation for all the alternative portfolio strategies, we find that flexibility turns out to be of key importance to individuals for both portfolio and spending decisions. The performance of the adaptive dynamic goal-based portfolio strategy is found to be far superior to all the industry’s Markowitz-based approaches. Superiority is measured here by the certainty equivalent increase in expected utility of individual lifetime consumption (gamma) and the extra initial capital required by an individual to put the dominated strategy on the same expected utility footing as the optimal dynamic strategy (initial capital gap). These empirical results should put paid to the commonly held view amongst finance professionals that the extra complexity of holistic dynamic stochastic models is not worth the marginal extra value obtained from their employment. We hope that such approaches implemented in currently available technologies will rapidly find acceptance by individuals, financial advisors and pension funds to the genuine benefit of individual investors.

Keywords: Decision support system, Dynamic stochastic programming, Financial planning, Financial advice, Goals,Life cycle model, Retirement, Sustainable wealth, Risk management

JEL Classification: C61, D10, D91, G23

Suggested Citation

Dempster, M. A. H. and Kloppers, Dwayne and Osmolovskiy, Igor and Medova, Elena and Ustinov, Philipp, Life Cycle Goal Achievement or Portfolio Volatility Reduction? (March 30, 2015). Available at SSRN: https://ssrn.com/abstract=2586178 or http://dx.doi.org/10.2139/ssrn.2586178

M. A. H. Dempster (Contact Author)

University of Cambridge - Centre for Financial Research ( email )

Centre for Mathematical Sciences
Wilberforce Road
Cambridge, CB3 0WA
United Kingdom

Cambridge Systems Associates Limited ( email )

5-7 Portugal Place
Cambridge, CB5 8AF
United Kingdom

Dwayne Kloppers

Alexander Forbes Financial Services (Pty) Ltd ( email )

115 West Street
Sandton, 2196
South Africa

Igor Osmolovskiy

Cambridge Systems Associates Limited ( email )

5-7 Portugal Place
Cambridge, CB5 8AF
United Kingdom

Elena Medova

University of Cambridge - Centre for Financial Research ( email )

Centre for Mathematical Sciences
Wilberforce Road
Cambridge, CB3 0WA
United Kingdom

Cambridge Systems Associates Limited ( email )

5-7 Portugal Place
Cambridge, CB5 8AF
United Kingdom

Philipp Ustinov

Cambridge Systems Associates Limited ( email )

5-7 Portugal Place
Cambridge, CB5 8AF
United Kingdom

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