September 14, 2015

Monte Carlo Simulation

 

A brief history and how you can use this sophisticated technique to help map your future.

Since the mid-1920’s the return in the stock market has averaged about 10% annually.  Sounds great, right?  There’s a problem – the market doesn’t actually return 10% every year, it only averages that per year over long periods of time – typically 5 to 10 years.

So, if you’re trying to plan for your retirement and model what your future might look like, assuming you get 10% every year, year in and year out, could lead you to some wrong conclusions.

What to do? Well, you use something called Monte Carlo simulation.  It’s a little unfortunate that it’s called that because of the somewhat negative gambling connotation.  But what is the future, really, but a gamble – an outcome at least partially determined by chance and characterized by uncertainty.

The genesis of Monte Carlo simulation as it relates to possible investment outcomes was an outgrowth of the Manhattan Project at Los Alamos National Laboratory and was invented by a mathematician named Stanislaw Ulam during his work developing the atomic bomb.  Specifically, his work related to Monte Carlo simulation was developed while he was playing solitaire during his recovery from surgery.

The thought occurred to him that he could play hundreds of games of solitaire to “estimate statistically the probability of a successful outcome”, that is, winning the game.  Ulam often talked of his uncle, who had a certain proclivity to actually go to Monte Carlo to gamble, and thus the name was born.

Monte Carlo simulation allows us to consider and model thousands of possible investment returns and to determine the probability of, say, not running out of money before you die, given your asset base, risk tolerance, time horizon, and spending requirements.

So, rather than assuming the stock market goes up in a straight line (which we all know it doesn’t), Monte Carlo simulation allows us to model in a bunch of really bad and really good years of investment performance as part of the mix.  This helps create a much more realistic and robust view of how future investment returns might look and how their volatility might affect your future.

It’s really a great planning tool and we use it all the time with our clients to see how changes in behavior and the variability of the markets impact potential future outcomes.

Let us show you how this sophisticated technique can help plan your future.  Call today – .


Translate »