The first image of a black hole. Credit: Event Horizon Telescope collaboration et al. |

What do relativity theory, quantum mechanics and retirement planning have in common? Not a lot and that's actually an important point.

Black holes were implied by Einstein's work on general relativity in 1915 but the first one wasn't discovered until 1971[1]. Physics was able to predict the existence of one of the largest elements of the universe 56 years before one was discovered.

At the other extreme, on the quantum scale, Peter Higgs and five other scientists proposed the existence of the Higgs boson in 1964. Its existence was confirmed in 2012 based on collisions in the Large Hadron Collider at CERN. The existence of the Higgs boson was predicted 48 years before it could be confirmed.

In retirement planning, we do well to predict finances somewhat accurately more than a year or two in advance. Retirement planning is clearly not rocket science.

Physical sciences and their predictions are based on physical laws of the universe. Acceleration due to gravity on Earth is about 9.8 meters/second

^{2}, or about 32 feet per second per second as we Boomers learned in high school physics back when a meter in the U.S. was something one paid a quarter to park. On Mars, it's about 3.7 m/s

^{2}. Light travels at about 300,000 kilometers/second.

Drop an object from a height of 10 meters on earth and we can predict that it will reach the ground in 1.43 seconds traveling at 14 meters/second at impact. We can build models that predict such things with great accuracy.

Economics, however, is a social science, not a physical science. Finances can be modeled mathematically but actual outcomes are highly dependent upon the behavior of the humans involved. That makes the models far less predictive.

Unlike the universal laws of physics, the inputs for financial models are often unknown, so we make our best guesses. The most important factor of retirement finance, how long you and your spouse will live, is largely unknowable. Half of a group of people like you may live another 18 years but

*you*might live twice that long or get hit by a bus tomorrow.

We know that stock markets have returned about 9% a year over the past 150 years but you won't be retired for 150 years. The geometric rate of market return you would have historically experienced over any single 30-year retirement during those 150 years could have been less than 3% per year or more than 10%, depending on the year you retired. The range of returns is broader for shorter periods.

[Tweet this]Black Holes, the Higgs Boson and Retirement Planning.

Retirement models, whether mathematical, spreadsheet, or Monte Carlo simulation, can't predict the future the way models do in the physical sciences. Monte Carlo simulation was developed for the Manhattan project and was accurate enough to help develop the atomic bomb when the world had minuscule computing power. MC could predict how atoms would behave but it can't predict your retirement finances.

In 2001, William Bernstein published a blog post entitled, "Of Math and History" noting that "it’s the engineers who most often give me the willies."[2]

"The trouble is, markets are not circuits, airfoils, or bridges—they do not react the same way each time to a given input. (To say nothing of the fact that inputs are never even nearly the same.) The market, though, does have a memory, albeit a highly defective kind, as we’ll see shortly. Its response to given circumstances tends to be modified by its most recent behavior. An investment strategy based solely on historical data is a prescription for disaster."(It's a great read, by the way, as is just about everything at

*EfficientFrontier.com*.)

There is huge risk in believing that we can accurately predict our financial future, market risk or returns, a safe amount to spend annually from our savings portfolio, our optimal asset allocation, our probability of successfully funding retirement, or any such metric with any degree of accuracy for any period beyond perhaps a couple of years, let alone for a retirement that could last 30 to 40 years.

I recently told an audience at a retirement finance conference that the greatest risk of retirement is overconfidence. Believing you can accurately predict the things in the previous paragraph is a prime example.

You might rightly ask, given my perspective of uncertainty, why I spend much of my retirement days building simulation models. The answer is that I don't use the models to predict probability of ruin or to predict anything, for that matter. I use them to study many possible outcomes for hints for improving my retirement plan. I readily admit that I have no idea which simulated scenario, if any, ultimately will be similar to mine. I just want to find the bad outcomes and say, "Whoa! How can I avoid

*those*?"

I was once asked what I think is wrong with spreadsheet models of retirement. My answer is that they only consider a single possible scenario and not a realistic one, at that. It is highly unlikely that you will live precisely 30 years in retirement, for example, and there is an infinitesimal probability that your market returns or expenses will be the same each of those years.

(You could run a spreadsheet model several times with different assumptions, of course, but you can generate tens of thousands of different scenarios in a few seconds with MC.)

The tools we use in the physical sciences can be useful in social sciences like economics but they cannot be as predictive because people, unlike atoms, are unpredictable. Computerized retirement models can look impressive when a computer spits out thirty pages of Monte Carlo simulated data but less so when one considers the huge assumptions that have been input into the program. Computers and simulation cannot remove risk from your retirement but they can help identify and understand it.

In an earlier post, I suggested that the most important retirement decision you will make is how much of your wealth to allocate to safer income assets and how much to risk in the market. Don't be overconfident in your ability to predict the risk and returns of the latter. Have a backup plan (a floor of safe income) in case of portfolio failure. Retirement models are simply the best estimates we can make of a largely unknowable future.

And, if someone tells you that you will die with $5.3M in your investment portfolio or that you can spend 4.27% of your portfolio balance annually with a 95% probability of not outliving your savings for at least 30 years, consider that with a large dollop of skepticism.

Remember when you're considering your retirement plan that all models are wrong but some are useful.

Zvi Bodie explains "America's best-kept secret", I bonds for inflation protection.

The American College of Financial Services has created a wonderful collection of brief video interviews with Rick Miller on topics of personal financial planning.

REFERENCES

[1] Who Really Discovered Black Holes?, BBC Science Focus Magazine.

[2] Of Math and History, William Bernstein.