Understanding Performance Models in Financial Planning

What is a Model?

Because the full investment market is large and complex, reviewing macro performance doesn’t always help in planning for your specific needs or account. Models compile only relevant performance indicators from a select group of assets and chart their performance given certain circumstances.

A common example is building a model of fund performance over the last 10 to 20 years for a select group of holdings that closely mirror an individual’s planned strategy. This allows you to model how those funds would have performed over time, giving you a more accurate understanding than looking at the performance of the entire market over the same time.

Models may also be used to chart future performance given certain market conditions, although evidence-based investors like Plancorp understand markets to be unpredictable making that exercise unhelpful.

In the financial world models are sometimes referred to as hypothetical data because they likely don’t match an exact portfolio and cannot capture every external condition. For instance, your personal portfolio may include stocks gifted to you from a relative or through a program at work, changing the makeup from a model.

When and Why Do We Use Them?

Consider a situation where you are planning a picnic and only have the weather from the last 7 days to plan. Although both might be generally helpful to know, there would be a big difference between hearing the weather for the entire country as compared to your specific area. You would also understand that even the more relevant information for your area cannot perfectly predict whether a storm might interrupt your afternoon.

The ability to focus in on the performance of a certain model over time allow analysts, planners, and Wealth Managers to make informed investment decisions that match your personal goals.

What Are Their Limitations?

A model is only as good as the information available, and evidence-based investors will reiterate that you should consider models for illustrative purposes only. Long story short, a model can never fully predict the future.

Inherent limitations of model performance may include:

• Model calculations make certain assumptions (e.g. concerning expenses) and changing those assumptions may have an impact on the returns or real-world decisions around it.
• Model results are generally prepared with the benefit of hindsight, boiling down 20 years of market forces to a single chart, meaning that exact collection of assets may not have been chosen without knowledge of how they would perform
• Not everything can be captured in a model, such as material economic factors that might have an effect on an advisors decision-making process managing actual assets.
• Complex market factors, many of which cannot be fully accounted for in the preparation of hypothetical performance results, may adversely affect actual investment results.

In short, models help us make informed decisions, but hypothetical performance is not indicative of future results. Your team at Plancorp is here to help and we specialize in making the complex simple and easy – if you ever have any questions about a model or it’s limitations please ask.