Proper financial planning starts by creating a personal balance sheet, projecting future cashflows and comparing outflows with expected income. Such financial plans project future cashflows in great detail and can include, among others, future salaries, savings, housing costs and pension schemes, whilst taking all of the relevant tax regulations into account. The level of sophistication at which the cashflow projection takes place often strongly contrasts with the way investment returns are projected.
Traditionally only the expected return or a few deterministic return scenarios are taken into account for the investment decisions. As future incomes heavily depend on uncertain investment returns, not taking stochastic scenarios into account heavily undermines the overall quality of the financial advice. In this article, we demonstrate the use of stochastic scenario analysis, and demonstrate how the quality of financial advice can be greatly improved by properly balancing risk and return in order to align with the client’s desired risk appetite and the priority given to the investment goals.