Blog

Monte Carlo comes to Malvern?

Gerald D. FaheySeptember 2, 2016

Financial Planning

Clients sometimes ask us about Monte Carlo being used in our financial plans, so we thought we’d take a closer look at this topic and how it is used at our firm.  We are not talking about Monte Carlo, the city in the country of Monaco, known for its gambling and being the second smallest and most densely populated country in the world! 

The technique of Monte Carlo was first used by scientists working on the atom bomb and has been used to model a variety of physical and conceptual systems since World War II.

Monte Carlo for our purposes allows us to simulate the impact of various investment return scenarios over many years and ultimately make conclusions to determine the probability of success of a given financial plan, using the various assumptions built into it.  In many cases, we build multiple scenarios for a client or prospect to consider and work together to determine the version most suitable for their needs.

Anyone thinking or preparing for retirement should pay attention to Monte Carlo simulation!  Given world events and their potential impact to your portfolio, Monte Carlo Analysis provides financial planners an important tool to demonstrate the inherent risk and uncertainty with your holdings. By utilizing this type of analysis we are able to simultaneously adjust for inflation, spending, contributions,  investment returns and reinvested dividends/interest. 

Monte Carlo simulation repeats this process over and over again (in some cases hundreds and thousands of times) which results in a probability distribution of possible outcomes.  Through the pattern or model that eventually emerges we can better understand how changes to your plan will affect the likelihood of success. While Monte Carlo Analysis serves as a great tool during the planning process, it should be noted that it is one of many and should never be relied upon as the sole basis for any one recommendation. It is unrealistic that an average rate of return would be used in a financial plan because prudent long term strategies are not built that way!  All markets – financial, real estate and otherwise, experience ebbs and flows over time and the dynamic nature of these should be an integral component of the analysis.  The simulations used in Monte Carlo are able to capture not only the directional swings of the market but also the severity and length of them, and any combination in between.

If the conclusion from the Monte Carlo simulation is not a tenable one for the client (yes, we sometimes  introduce the unpopular notions of retiring later, saving more or spending less), it is just as important to discuss alternatives to your strategy that may result in a greater probability of success!  Ideally, these conversations are taking place several years before your targeted retirement date or any other stated goals, so that there is time to make adjustments as necessary.

Even in retirement, Monte Carlo can be used to monitor progress within an existing financial plan or to model sudden changes in health or life expectancy, in addition to longevity.  While most plans reflect the standard 25-year time horizon spanning ages 65 – 90, we are sometimes tasked to include an early retirement scenario of perhaps, age 60, or a longevity case where a plan is adapted to a life expectancy of ages 95 or 100.

Remember that Monte Carlo simulation is determining probability and not certainty!  Even with the current level of sophistication provided within Monte Carlo, it is built upon baseline assumptions and any action plan or recommendations that may result should fit within the overall framework of your financial plan.  Still, it can be an extremely valuable tool when attempting to forecast the unknown futures of individuals, couples and in some cases, generations!        

Sources:

Retirement Nest Egg Calculator
Monaco – Google
Monte Carlo Simulation
NaviPlan Central
RiskAMP – Monte Carlo Simulation