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I kicked a hornet's nest last week when I asked my colleagues about retirement calculators. It all started when I quoted Paul Kaplan.

Paul Kaplan, Ph.D., CFA, is Director of Research at Morningstar Canada. Paul is also author of "Frontiers of Modern Asset Allocation", which I reviewed last year.

I quoted Paul in an article last week about the simultaneous plunge in gold, stocks, and commodities. I said that we shouldn't read too much into Monday's convergence of correlations, and this is true. But then I quoted Paul to make a point about online retirement tools, and I wound up quoting him out of context.

My Critique of Retirement Calculators

Online retirement calculators are popular tools that help investors project the growth in assets over time, based on different mixes of assets. My concern arises when these calculators are used to:

• Mindlessly extrapolate the past
• Offer a precise estimate of the future

I am always wary of the potential for mathematical models to be misused by investors (including myself). So I made my point about retirement calculators by quoting Paul Kaplan, who wrote in his book "Historical results should not be blindly fed into an optimizer." (I love this quote and use it often.)

Paul's Response

Unfortunately, Paul was referring to Mean Variance Optimization (MVO), a process that uses expected returns, volatility, and correlations to optimize asset allocation. Paul pointed out this out to me, and he also noted that retirement calculators typically use Monte Carlo simulations, not optimization.

Schwab's Tools

I checked the retirement calculator at Charles Schwab and it turns out that Paul is right: Schwab uses Monte Carlo simulations. Moreover, Schwab's retirement calculator uses assumptions about long-term market returns that seem quite reasonable to me, and which are not an extrapolation of past returns. (Extrapolation is especially worrisome for U.S. government bonds, which have enjoyed a 30-year bull market, and which are not likely to stage an encore.)

Oh, and One More Thing…

In my prior article I also said: "Monday's broad sell-off across asset classes is a good time to highlight the fatal flaw in static optimization models: Correlations change."

Paul responded thus:

I disagree, because the models themselves make no predications about such short-term events. You then say "Days like Monday are a reminder of the weaknesses of automated tools that help investors plan for retirement."

What you call a weakness I call a strength! If using a long-term planning tool helps keep investors' eyes on the long run and helps them ignore the financial journalists when they read too much into a one-day event, then I'd say they've done investors a service!

I stand corrected. My thanks to Paul for pointing this out, and for highlighting a proper role for retirement calculators.

Volatility Management for Retirees

I find it useful to run a retirement scenario for clients since they are surprised to find out how devastating a bear market can be during retirement. It all depends on the timing of the downturn: The portfolio is especially vulnerable early in retirement, since withdrawals at a cyclical bottom cannot be recovered. This makes it much less likely that the portfolio will last for the client's lifetime, so volatility management is critical for retirees.

A 60/40 mix of stocks and bonds is the classic solution, since bonds have historically had a low correlation with stocks. Unfortunately, most retirement calculators limit the asset classes to stocks, bonds, and cash, which I see as a problem:

• With Bonds: Let's say I use a 60/40 mix of stocks and bonds. Right now that means owning a lot of bonds when interest rates are at historic lows, and when Treasurys offer negative real returns. That's not a recipe for a happy retirement.
• Without Bonds: If I do not buy bonds, especially government bonds, then the portfolio will be much more volatile. This leaves it vulnerable to a market downturn early in retirement (the dreaded "sequence of returns" problem).

Annuities and Alternatives

Two of my favorite solutions for volatility management are annuities and alternative investments. Annuities get a bad rap because of high commissions, and retirees certainly must be wary of unscrupulous salespeople. But since annuities can offer guaranteed income for life, they are a valuable ingredient in the retirement planning, depending on the client's liquidity needs.

My other favorite solution is alternative investments, and I use the following:

1. Real Assets to Hedge Inflation: These assets include precious metals, Real Estate Investment Trusts, and Master Limited Partnerships. I own the iShares Gold Trust (IAU), the Schwab U.S. REIT ETF (SCHH), and the JP Morgan Alerian MLP ETN (AMJ). These assets provide both income and an inflation hedge. In addition, IAU has a particularly low correlation to stocks, and it provides a hedge against tail risks.
2. Alternative Assets to Reduce Correlation: This includes hedge fund and private equity strategies, which typically are not highly correlated with the stock market (depending on the strategy). My holdings include the Barclays S&P 500 Dynamic VECTOR ETN (VQT), the Arbitrage Fund (ARBFX), and the KKR Alternative High Yield Fund (KHYZX). The VQT dynamically reduces exposure to equities as volatility rises; ARBFX is a merger arbitrage fund, and KHYZX is a high-yield strategy that relies on the same fundamental credit research that KKR uses for its private equity strategies. Thus, even though it is a high-yield fund, it tends to be more defensive than most, since the portfolio management process is focused on downside risk.

Since I am strategically underweight in U.S. government bonds, I find these assets helpful in providing volatility management for retirees. (This example is for small accounts; high net clients may add traditional hedge funds, venture capital, etc.) Retirement calculators may not be able to use all of these strategies, but I find them a useful exercise to get clients to focus on long-term goals.

A Stinging Critique From Ed Stavetski

Not everyone is a fan of these calculators, however, as I learned when I asked another colleague in the investment business, Edward Stavetski.

Ed is the founder of PCM Partners LLC, a firm that provides asset allocation research, due diligence, and business valuations. So for Ed, retirement estimates are not an abstract math problem. Ed reframes the issue of retirement planning like this:

I prefer to start an asset allocation based on what the client requires, rather than starting with capital markets. I take their needs and add a premium (call it an inflation premium or a risk premium). Then I adjust the market exposures based on the client's risk profile.

By the way, risk is not relative to an index, and risk is not volatility: Risk is the permanent loss of capital.

I like Ed's perspective since it shifts the focus onto the goal of the portfolio, and since it redefines risk in a way that makes sense for the client. Sometimes people can be too glib about investment volatility, especially when they imply that "it all works out in the long run." This overlooks the fact that people retire at a relatively fixed point in time, and volatility early in retirement can be a killer.

The impact of volatility on retirement income was called the Retirement Red Zone by Prudential. In this marketing campaign, Prudential compares the years before and after retirement to the red zone in American football. I think this is a clever way to highlight how volatility reduces returns when an investor is withdrawing money. And let's face it, talking about the Retirement Red Zone is a lot catchier than talking about "the sequence of returns problem for portfolios in distribution."

Models Behaving Badly

Ed's critique of retirement calculators is actually a general critique of quantitative analysis, particularly when it is misused to the detriment of clients:

Modern Portfolio Theory, Mean Variance Optimization, and Monte Carlo are all the same. Whether it's expected returns, historical returns, volatility or correlations, they are all based on historical views and forecasts of future reactions. Academics for decades have ridiculed tactical asset allocation and market timing as nothing more than wild guesses as to what markets will do, and which are unreliable at best. But at the end of the day, what is MPT, MVO and Monte Carlo? Wild guesses based on precise mathematical calculations out to four insignificant decimal places.

Ouch.

Ed is actually critiquing something much broader than retirement calculators. He is criticizing the false sense of precision that sometimes emerges from quantitative finance. Warren Buffett also has a disdain for complex math, and this article collects his quotes on the topic. It also reminds me of Models Behaving Badly, which is subtitled "Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life." This book explains why mathematical models can never truly capture human behavior, and why a heavy reliance on models can be so dangerous.

The Portfolio Manager as Fiduciary

More fundamentally, Ed is raising philosophical issues about the fiduciary role of a portfolio manager. As fiduciaries, it is our responsibility to preserve client wealth and purchasing power in the face of uncertainty. We can't escape our responsibility by using retirement calculators as a substitute for sound judgment. We can't pass the buck and tell our clients: "Sorry, the model failed and your portfolio crashed. Your retirement will feature cat food, not caviar."

Links to 21 Retirement Calculators

With that caveat in mind, I asked Alan Johnson for his opinion. Alan is the founder of Johnson Harper, LLC, a registered investment advisor in NJ, and a contributor to Seeking Alpha.

Alan has spent a lot of time comparing different tools on the web, and his handy reference article compares 21 different retirement calculators. The post has links to each retirement tool, and he notes whether each is a calculator or a simulator (which allows the user to adjust historic returns and volatility).

Closing Thoughts About Use vs. Misuse

Alan and I tend to think alike about retirement calculators. Calculators are necessary tools, because you have to make some kind of estimate to create a financial plan for clients. These estimates may spur people to save more, to think about long-term goals, frame, and to focus on the aspects of retirement that they can control (such as their retirement age and spending habits. So in this sense, retirement calculators have a useful role.

But these financial estimates of the distant future are very sensitive to the inputs, so the outputs should be considered guesstimates. Consequently, I do not like the commercial from ING that has people walking around with their "number". To me, this implies that investors can achieve financial peace of mind by finding a number that precisely quantifies their retirement needs. This is a misuse of retirement calculators.

Then again, if an investor genuinely expects to achieve security in life through a number, they probably need a reminder that retirement planning is merely a means to an end. As Philip Fisher said:

"The stock market is filled with individuals who know the price of everything and the value of nothing."

Disclosure: I am long IAU, SCHH, AMJ, VQT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long: ARBFX, KHYZXAll written content is for information purposes only. Opinions expressed herein are solely those of Right Blend Investing and our editorial staff. Material presented is believed to be from reliable sources, however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. The presence of this article shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services to any residents of any State other than the State of New Jersey or where otherwise legally permitted. This is not a complete discussion of the information needed to make a decision to open an account with Right Blend Investing, LLC. There are always risks in making investments, including the investment strategies described.

Education is critical for the novice investor, but topics like portfolio construction aren't exactly a barrel of laughs. This article considers how gaming technology may be used for investor education someday soon, and it shows lessons investors can apply today.

For the savvy investor, modern technology makes it is easier than ever to build a diversified portfolio. As an investment advisor, I manage retirement portfolios using a variety of tools at Fidelity, Charles Schwab, TD Ameritrade, and other discount brokers. Personally, I believe these platforms are the best place for investors with $250,000 or less in assets. Discount brokers now offer portfolio analytics, market analysis, low-cost funds, and commission-free funds, as well as advanced trading and investment solutions. Used properly, all of these resources are an investor's dream: They can cut costs, manage risk, lower taxes, and improve potential returns.

There's just one problem: Many investors have no idea how to use all of these resources.

Don't get me wrong: Most people have no problem with the basic concept of low-cost diversification, such as the core/satellite approach I described here on the CFA Institute website. These models use Modern Portfolio Theory, which most people can understand without too much fuss. Unfortunately, these days, a simple stock and bond portfolio is only the beginning.

Alternatives

One of the fastest growing investment categories over the last five years has been alternative strategies offered in ETFs and mutual funds. These products allow investors to buy nontraditional assets such as real estate and commodities. The alternatives space also includes offer access to "absolute return" strategies, which have previously been available only via hedge funds. As a Senior Analyst at FRC, a division of Asset International, Inc., I specialize in the analysis of alternative ETFs and mutual funds. Investors are embracing arbitrage funds, long/short equities, and other strategies as a way to build a more fully diversified portfolio. These products can help investors build more fully diversified portfolios, and adapt rapidly to changes in the markets or changes in their goals.

The Educational Challenge

Alternative products are much harder for investors to figure out, and they need help in understanding correlation and the finer points of portfolio construction. Without this education, investors may expect more from alternative products than they could ever deliver.

As I noted above, the there is no shortage of online tools for investors. Today's Do-It-Yourself tools are fast, free, and mathematically precise. What they are not, however, is fun. This brings us to…

The "Angry Birds" Portfolio Builder

Imagine, if you will, what the future might hold if investment companies teamed up with the best minds in online gaming to create new tools for investor education. Angry Birds has been a big hit on mobile phones and other devices, and shows that simple games can engage people of all ages. Here are some headlines you might read in days to come:

1. January 1, 2014: "iShares Releases Angry Birds Portfolio Builder, an App for PCs and Mobile Devices." iShares has teamed up with Rovio to produce an educational program that shows investors how to build diversified portfolios with a variety of ETF products. Investors can learn how to use iShares to create low-cost portfolios portfolios, and they rack up points as they advance from conservative mixes of stocks/bonds/cash to aggressive mixes that include alternative investment strategies.
2. January 1, 2015: "iShares Releases Angry Bird Investor 2.0: When Pigs Fly" This release brings back investor favorites like the "Bond Buffalo" and the "Dividend Dalmatians," while adding new variations in Modern Portfolio Theory. Experienced investors will love the fully-diversified endowment model: The Golden Egg Level allows investors to input their own assumptions for the risk-free rate and asset class returns.
3. January 1, 2016: "AQR Capital partners with Zynga to release FundVille and HedgeFundVille." These educational guides offer both basic and advanced investment strategies. Cliff Asness provides the voice for Professor Penguin, who teaches about merger arbitrage and managed futures. Connect with your favorite social media sites while collecting ribbons, mysterious animals, and advancing to new levels!
4. June 1, 2016: Charles Schwab allows trading directly from the iPhone app of "Angry Bird Investor 3.0." It offers a $100 bonus to clients who complete 30 levels, or who connect to 30 friends.
5. September 1, 2016: "CFA Institute Announces It Will Accept 'FundVille' Points Towards Continuing Education Credits" (This is when we know that end times are upon us.)

Why Games Make Sense for Investor Education

Some people will say that gaming trivializes investing, which is a serious topic. But if the underlying principles are the same, it should not matter how it is illustrated. For example, building a diversified portfolio relies on mathematical assumptions about how different assets should be combined. Here is a typical illustration of the principle:

This exhibit covers the bases without any fanfare. Unfortunately, it is not likely to engage the average 401(k) investor, who would rather be watching TV or surfing the Internet. Given how hard people have to work for their money these days, I cannot fault anyone for being stressed out and starved for time. So why not try to make the process a little less painful?

The exhibit below also illustrates diversification, but it uses different images to for each asset class:

1. Stocks are illustrated with green leaves, representing growth
2. Bonds are illustrated with a milk cow, representing steady income
3. Cash is illustrated with a money bag
4. Alternatives are illustrated with a globe, representing an expanded range of possibilities
5. The overall portfolio is illustrated with a piggy bank

The second illustration describes the same concept, but in a more entertaining manner. After this lesson, it takes just a few more steps before we are throwing mud pies at pie charts, and building a balanced portfolio. The underlying math is the same, only the surface layer is different. Before you know it, we have passed level one, and we've moved from basic asset allocations to a lesson in the volatility of returns. All by tossing a few mud pies on our iPhone.

Solitaire, Baseball, or Whatever Works

The form of the game does not matter: "Angry Birds" might resonate with younger investors, while solitaire is likely to resonate with retirees. (In part 2 of this story I use baseball to illustrate a concept.) Whatever the form, games are likely to be the next step for investor education. A quick perusal of the educational apps at Apple show a variety of colorful games, so "Angry Bird Investor" might be just around the corner. (These financial apps are likely to be free, considering the potential for advertising, and for gathering data about investor preferences.)

Math, Repetition, and Probability

One of the benefits of games is that repeat play will show how wildly results can diverge, even when using the same strategy in the same situation. This is all part of the game of investing, which always has seats at the table reserved for ambiguity and uncertainty.

Indeed, while investors can learn a lot from mathematical simulations, they will also learn that models are only models. Models replicate reality, they don't create reality. (For details, check out Models Behaving Badly, which describes the disasters that can happen when people forget the limitations of mathematical simulations.)

Go Ahead, Play With Your Food

Perhaps games such as "Angry Bird Investor" will make it fun to play with the asset allocations in your 401(k). Game players will be able to experiment with their retirement assumptions, all at the touch of a button.

Next thing you know, investors would start to play with the assumptions behind the model. What will inflation be? What is a reasonable rate of return for stocks? Game players will start to write their own rules, and see how closely it matches reality. Finally, investors may develop completely different "worlds" to help illustrate different economic assumptions. Gaming allows you to see the consequences of your assumptions more clearly, as well as the differences between your assumptions and someone else's worldview. Playing with your assumptions can be both entertaining and informative.

In fact, playing with the rules might be the best education of all-especially when investors graduate from ignorance, and are ready to take responsibility for their own financial futures.

Investment Lessons from Baseball, Football, and Solitaire

Addictive games such as "Angry Birds" have opened the door to educational games for iPhones and smart phones. In part 1 of this story, I discussed how this might play out, and in this article I offer some lessons from games such as baseball, football, and solitaire.

The first lesson comes from baseball, which helps explain why it is so difficult to spot small statistical differences. This example shows how difficult it can be to beat the market, and how difficult it is to identify winners.

Why Is It So Hard to Find a Good Investment?

In baseball, one of the key measures for hitters is their batting average. Right now the batting average for all players in Major League Baseball is .255. This means that, players have gotten a hit 25.5% of the time they come up to bat. A "300 hitter" is someone who gets a hit 30% of the time, and this is generally considered a great batting average.

There is a big difference between a 300 hitter and a 250 hitter. If you could fill your team with 300 hitters, you would probably make it to the World Series even if you had bad pitching and bad fielding. In 2012, the Texas Rangers had the highest batting average in baseball. Their batting average was 273. This compares to 255 for the average team in MLB. This means that the top team in 2012 only hit the ball 2% more often than other teams. That is 2 hits out of 100 times at bat.

How many hitters would you have to watch in order to tell if one team was 2% better than another? Well, if you watched 1,000 batters, you could be 95% sure that one team was 2% better than another, and your margin of error would be about 1%. (Data calculated by Research LifeLine.) That's actually a pretty big margin of error, since you are trying to measure a 2% difference.

If you had a strategy that was profitable 52% of the time, how could you tell if it was more than just luck? Let's say you are putting $1,000,000 at risk, and you want to be 99% sure that this strategy works. And let's say you want to know within a margin of error of 0.5%. How many trades would you have to make to know if the strategy actually was profitable 52% of the time? You'd have to make about 5,000 trades.

That's a lot of trades.

Implications

This example shows that tiny differences often separate the winners from the losers, but they can be very hard to spot. The implication for investors is that you should have modest expectations about your ability to pick stocks, mutual funds, or even investment themes. This is true whether you are managing your own money or if you are delegating it to someone else. This example reminds professionals and amateurs alike that it is very difficult to spot a winner, even after many games have been played.

(click to enlarge)

Football and Diversification

The concept of diversification can be hard for investors to truly understand. Diversification sounds like a great idea, until you own something that goes down while the rest of the market goes up.

For example, I often diversify client portfolios using a basket of commodities as a small position. The most frequent questions I get are: "Will it go up now? Is it time to buy?" The whole idea of risk control through diversification has already gone out the window.

This is a common response from clients, so I recently used football as a metaphor to explain diversification. Football teams have offensive positions, defensive positions, and special teams. These squads have different strategies and tactics, but the team has one coach. And when everyone works together, the team is more likely to win.

Likewise, your portfolio also has both offensive and defensive positions. Each position has plays a different role, at different times, for different reasons. But there is one portfolio manager who ensures that it all works together. That's diversification, and that is how it helps you reach your goals.

For more sophisticated investors, I take the football metaphor one step further. In 2009 Sandra Bullock starred in The Blind Side, which gets its title from the role of the left tackle. This position protects the quarterback's blind side (since most QB's are right-handed, they have a blind side that's protected by the left tackle). The role of the left quarterback is simply to protect the QB from threats that he cannot see.

Likewise, a position in gold can protect a portfolio from threats the portfolio manager cannot see. The role of gold is to protect the portfolio, and not necessarily to generate growth. So gold is like the portfolio's left tackle, and its role is to manage tail risk

This is getting complicated, so let's return to solitaire.

(click to enlarge)

Lessons From Solitaire

Many folks in my parent's generation can relate to Solitaire, which Microsoft introduced in 1990 to help people become more comfortable with computers. It certainly worked, and my mom is living proof: She may not be a computer whiz, but she can play Solitaire on both a PC and an iPad.

Since Solitaire is familiar to an entire generation, I thought I'd share some tips from Warren Ward that connect it to investing. I'll paraphrase a few lessons below about planning, timing, and patience:

1. Success in Solitaire requires a concentration on priorities and on playing cards in the right sequence. Likewise, your financial goals require prioritization and planning for efficient execution
2. Sometimes you need to move backwards before you go forwards. Solitaire allows players to remove cards from the foundation, which might create a new opportunity to play a card from the deck. Likewise, investors may have to go backwards, and take losses on a position in order to move forward with a clean slate.
3. Don't make a move "just because it is available." In both Solitaire and investing, patience pays off.

Three Reasons Why Investment Games Make Sense

These metaphors resonate with people because they use familiar objects in a new way. There are countless opportunities to do this with all types of investment games, and make life a lot easier for the average investor.

There are many other reasons that games make sense for investor education, and I'll point out three: Trust, time, and training tiers.

One of the greatest challenges with investor education is that people want sources that they can trust. Most applications on the web are product driven, or are a clever sales pitch that tends to favor a certain solution. An investment game avoids this, since the sole goal is learning. This assumes that the foundation of the game is mathematics, which is independent and objective. Math also makes an excellent foundation for gaming worlds, so there is a natural fit between investments and gaming.

Another challenge is that education takes time. It takes years to become an educated investor since the topic is complex and pitfalls are everywhere. But if the games are fun, time is less of a challenge. Moreover, people should be motivated to spend the time to learn from others. As they say, "Smart people learn from their mistakes; wise people learn from other people's mistakes."

Finally, investor education does require tiers. This vexes investment companies that develop educational content: The audience has a wide range of experience, so content that helps some people will be boring to other people. Gaming applications naturally tend to have levels, with easy ones first and harder ones later. This is ideal for investing, since you need to know the rules before you criticize the rules. (Frist you have to learn Modern Portfolio Theory; then you can criticize it and develop Post-Modern Portfolio Theory.) So it helps if the audience chooses the tier that suits them, and trains accordingly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: seekingalpha.com/author/right-blend-inve.../instablog

All written content is for information purposes only. Opinions expressed herein are solely those of Right Blend Investing and our editorial staff. Material presented is believed to be from reliable sources, however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. The presence of this article shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services to any residents of any State other than the State of New Jersey or where otherwise legally permitted. This is not a complete discussion of the information needed to make a decision to open an account with Right Blend Investing, LLC. There are always risks in making investments, including the investment strategies described.