What is Monte Carlo Analysis? (and why it is important to you)

If there’s one question on every investor’s mind, it goes something like this: “How am I doing so far?” This universal query is especially relevant when you’re making plans to retire or pursuing other substantial financial goals.

Since we cannot accurately predict the future, Monte Carlo simulation allows for risk analysis and decision making using a mathematical computer model applying quantitative analysis theory. Monte Carlo Analysis allows you to see alternate possible outcomes and measure the impact of risk on your decisions. Don’t let the casino-inspired name fool you. The computer software calculates the odds that any given financial plan will play out as hoped for, based on the likely range of plausible outcomes, from awful to amazing.

How Monte Carlo Analysis Works

Behind the scenes, Monte Carlo calculations are quite complex. It applies future assumed returns to a stream of cash flows which incorporates variable return risk, timing sequence risk, and mortality risk. The first step is inputting a number of factors that reflect your unique circumstances, along with a few broad assumptions. We typically identify and input at least the following particulars:

Net worth
Sources of income
Investment profile (expected asset class rates of return)
Debt load
Spending goals
Inflation rates
Life expectancy
Legacy goals

The software then runs thousands of iterations that generate a broad range of possible outcomes from the best to the worst, and mostly in-between outcomes you might experience over the next few years or decades, given your circumstances and depending on how things play out in real life.

For example it is reasonable to assume you will earn a particular Average Return over a long period of time. However, you will not get the Average Return each year. Future rates of return are uncertain. Your actual returns will vary widely year-to-year, and the sequence of those variations make a big difference in your planning.

If you are making withdrawals from your portfolio, and get the Average Return you expect over some specific period of time, the future value of your portfolio can still vary greatly depending on the actual sequence of returns you get each year. If you are unlucky enough to suffer losses in the early years, you may run out of money much sooner than expected. If you are very lucky and have big gains early, your money will last longer.

In other words, we cannot know what the future holds. But we can generate relatively reliable expectations for questions such as:

What are the odds you’ll still be okay, even if worse comes to worst?
How much better off will you be if you receive every lucky break that heads your way?
How can you expect to fare as you encounter the usual mixed bag of good news and bad?

The results of your personalized Monte Carlo Analysis should provide you with a realistic picture to consider. Each analysis shows different odds of “succeeding” with any given financial plan.

These simulations can also give you an idea of what might happen if you spend more or less than planned, live a longer or shorter life, or invest more or less aggressively in your portfolio. For example, if you spend 10% more and live to age 90, your success rate would drop.

Are you comfortable with these odds? If so, we can plan accordingly. If not we continue to tweak the assumptions until we’ve arrived at acceptable odds. For example, we could see what your analysis might look like if you decided to:

Work longer before retiring.
Spend less, now or in retirement.
Alter your investment portfolio mix.
Change life expectancy.

In an actual Monte Carlo Analysis, we cover a lot more ground. Either way, beyond presenting a single “success or failure” percentage point, the analysis also provides a dollar range you’re expected to fall into. You shouldn’t plan for a specific future Portfolio Value, but instead expect your result to fall within a range of possible values, depending on the Sequence of Returns you get. There is no way to project any specific future value. The best you can do is plan for a reasonable range of possible outcomes.

The Caveats: No Guarantees

As you might imagine, Monte Carlo Analysis depends heavily on the data. In other words, if we put garbage in – such as unrealistic spending goals or inaccurate portfolio balances – that’s exactly what we’ll get back out.

Time matters too. The further out we go, the more likely you’ll experience lucky breaks and bad outcomes not yet factored into the equation. Your own life may change, for better or worse. So might the markets, or inflation, or tax laws, or … you get the idea.

As such, Monte Carlo Analysis becomes less effective if we try to peer too far into the future. Especially as you approach retirement, your analysis should be re-run regularly, to ensure your numbers remain realistic. Bottom line: The more time you have to adjust your plans if needed, the more likely you’ll be able to continue spending comfortably before and in retirement without losing too much sleep over that all- important question – How am I doing so far?

Now What Do You Do?

Take the time to prepare a personal Financial Plan that addresses your unique needs and desires. It’s easier to do than you think, and it can really help you understand what it will take to reach your Financial Goals.

Disclaimer:

Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. Content should not be viewed as personalized investment advice or as an offer to buy or sell the securities mentioned. A professional advisor should be consulted before implementing any of the strategies presented.

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