Monte Carlo - Your Spin On the Wheel

What is 'Monte Carlo Simulation'? Sounds like something to do with gambling. Well it is, kind of - it's based on chance.

When our advisor tells us we will receive an eight percent return on our investments, which will grow to $3 million in 20 years, we might hope that this is a certain thing. In reality, such simple 'straight line, one pass' projections of investment returns don't take into account the variability of the market. What actually happens is that the growth each year is an unpredictable number within an expected range, and the end result depends on a series of these unpredictable individual returns.

Monte Carlo simulation, or MCS, is an analysis tool that allows investment portfolios to be subjected to variable returns and to different sequences of returns. The program is generates many series of random returns based on the assumptions, resulting in a statistical probability plot of likely results over an extended period of time. It is typically used to gauge if a particular combination of investments has a high chance of achieving the target accumulation amount.

The application of MCS in financial planning is largely misunderstood and does not really deliver the results advertised. To perform a Monte Carlo Simulation, the adviser enters assumptions about the rate of return and standard deviation of the different investment types. These assumptions are simple arithmetic averages of historical results. Arithmetical averages ignore compounding, but the Monte Carlo simulation calculates the cumulative performance of  these averages over many different sequences. What MCS actually measures and plots is the geometric mean of the advisor's assumptions. The geometric mean is a time-weighted average return. Many advisers struggle with the difference between arithmetic and geometric means, and think that MCS is 'testing their plan' when all it is really doing is calculating the outcome based on a geometric mean, not an arithmetic mean.  Almost the same result can be obtained by substituting the historic geometric mean for return and standard deviation in the straight line, one pass calculation.

It's a good thing for clients to recognize the possibility of variation in expected results! MCS is a popular tool with fiancial advisors because the input data is simple compared with other modeling methods, and the output is generally understandable by clients. Clients like it because it is closer to reality. However, a typical MCS result is that the client's account balance at the end of 20 years will be somewhere between zero and $5 million! No kidding! This throws the responsibility back at the client, who now has to decide if a 13% chance of running out of money is acceptable, or should he take less income to reduce this chance to 6%. The option given is usually to reduce portfolio volatility, that is, to go with a more conservative portfolio, which is likely to reduce returns and thus reduce the likelihood of achieving the client's original goals.

A limiting feature of the Monte Carlo evaluation process is that the asset allocation selected will remain fixed for the entire term, and thus has to be able to withstand this great variety of possible futures. Is there an alternative approach?  A good money manager will adjust the asset allocation according to overall market conditions, attempting to reduce the risk of short-term poor returns without equally reducing the ability to take advantage of short-term great years. Further, making withdrawals from the portfolio dependent on the investment results will counteract some of the effects of poor years. So in the end, it comes down to investing style, active versus passive, and how the retirement income is managed during draw down.

 In summary, Monte Carlo simulation is an analysis tool used to evaluate different portfolio asset allocations. Like any tool, there is a correct time for its use. The trick is not so much in how to use the tool, but when to use it. Stay on the line if you want to learn more about Monte Carlo simulation or to see a demonstration using your portfolio. Otherwise the next topic is about the importance of fees to your returns.

Call (408) 725-7135 to schedule an appointment to try your hand at a spin of the wheel on your portfolio, or click here for more free information.

Return to Free Info