The Low-down on Monte Carlo Simulations
If you’re around personal finance sites long enough, you’re likely to run across a term you might not be familiar with called a Monte Carlo Simulation. Monte Carlo simulations are pretty neat tools for planning but they’re not a crystal ball and have their limitations.
What is a Monte Carlo simulation
A Monte Carlo simulation is a method to simulate thousands of possible futures for a financial model. It applies in personal finance most commonly to retirement. It takes inputs like initial investment amount, future additional amounts, rate of return before and after retirement, years until retirement, rate of inflation and the like. The simulation then ‘tests’ the model against various possible futures to estimate the likelihood of a ’successful’ retirement result.
Why use one
Monte Carlo simulations can provide a better model of actual ups and downs of investment returns than simply using an average. For example, the graph below [courtesy T. Rowe Price]shows how using the average return from 1972 to 2003 of 9.51% would tell you your portfolio would be gone in 2003. However, if you look at the actual historical returns, your money would have run out in 1995 - a full eight years earlier. (The specifics of the scenario aren’t important, but if you must know them see this page and click on the ‘Tutorial’ link)
Limitations of Monte Carlo simulations
There are plenty of critics of Monte Carlo simulations, and for good reason. Monte Carlos tend to underestimate the possibility of have a lengthy bear market. They also fail to address how the sequence of future events affects the outcome. Finally, they do tend to lull an investor into believing they’ll definitely achieve success when you start throwing around terms like 95% or 99% success rate.
Bottom Line
Monte Carlo simulations can be one of many useful tools in determining things like what your retirement ‘number’ should be and how spending behaviors can affect your nestegg. However, stopping at a Monte Carlo simulation that says you’re 90% likely to achieve your retirement income goal would be a big mistake.
Where some are
Here are a couple of places I found free Monte Carlo simulations you can play with:
financial model, monte carlo simulation personal finance
June 12th, 2007 at 5:38 pm