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stochastic cashflow modelling or deterministic modelling

I saw something online asking if stochastic tools were a better option for adviser cashflow modelling than their deterministic counterparts What is the difference?



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This is a very good question because it is relevant to both cash flow forecasting and financial projections.

I have taken the following from an excellent blog on eValue’s website -

A Deterministic Model allows you to calculate a future event exactly, without the involvement of randomness. If something is deterministic, you have all of the data necessary to predict (determine) the outcome with certainty.

A Stochastic Model has the capacity to handle uncertainties in the inputs applied. Stochastic models possess some inherent randomness - the same set of parameter values and initial conditions will lead to an ensemble of different outputs.

Most financial planners will be accustomed to using some form of cash flow modelling tool powered by a deterministic model to project future investment returns. Typically, this is due to their simplicity.

Often, a single estimate for an investment return, such as 2%, 5% or 8%, is used to predict the future value of a fund or portfolio. This is the basis of deterministic forecasts, which produce a specific result for a specific input - every single time.

Deterministic models are typically used by product providers to illustrate statutory future projections of long-term investments (such as pensions). If the same projection rates are used, these forecasts can then be used to compare different providers, particularly around charges.

However, deterministic models do not make any allowance for the fact that markets are complex, irregular and ever-changing. As such, any model that is based on long-term average returns can be easily upset by the unexpected implications of sequencing risk, which can have a huge impact on a retiree’s income and lifestyle in retirement.

Stochastic Models, use lots of historical data to illustrate the likelihood of an event occurring, such as your client running out of money. These types of financial planning tools are therefore considered more sophisticated compared with their deterministic counterparts. A stochastic model will not produce one determined outcome, but a range of possible outcomes, this is particularly useful when helping a customer plan for their future.

Thanks again to eValue and do read their article

-- Edited by William Burrows on Sunday 30th of August 2020 10:51:10 AM

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