Code Name: Monte Carlo

Aug 13

What do you get when you assemble a dozen or so of nuclear science’s greatest minds, give them access to the world’s first electronic general-purpose digital computer, and spend $2 billion during the height of World War II? An atomic bomb of course, and a sophisticated simulation technique code-named Monte Carlo. Monte Carlo simulation was developed by scientists working on the Manhattan Project to predict the explosive behavior of the various atomic weapons they were constructing. Since then, researchers have successfully applied it to a vast number of scientific problems. Today, and many evolutions later, we use it to model the validity of your financial life plan.

Monte Carlo tools test the probability that your financial plan will do what it is designed to do by simulating thousands of scenarios. Each scenario is run by modulating inputs, such as returns, cash flows and inflation, to give a range of possible outcomes. Outcomes can then be graphed to show you and your advisor the likelihood of reaching your investment goals.

Whether your specific goals involve retirement, college savings or your legacy, Monte Carlo simulation is a robust way to stress test your financial plan. Unlike simple forecasting methods that rely on static return and cashflow assumptions, Monte Carlo simulation offers a way to test the outcome of an investment plan over a range of returns to account for the risk and uncertainty inherent to investing. Knowing your plan has been thoroughly evaluated against unfavorable market conditions and shown resilience not only gives you confidence that the plan is the right one for you, it can provide welcome peace of mind during times of market turbulence.

Accounting for return uncertainty is what makes Monte Carlo simulation such a powerful financial life planning tool. Monte Carlo simulations assume market returns vary from year to year and test your investment portfolio against a wide range of these possibilities. Results are typically shown in terms of your probability of success based on thousands of simulations. For example, if your investment plan is successful 800 out of 1,000 scenarios, your plan would be estimated to have an 80% success rate. Not unsurprisingly, our goal is to design and build an investment plan that has a high probability of success—high enough that you can be confident in the outcome, but not so high that the plan becomes overly restrictive. Together, we look for a number chosen specifically to help you stay on track toward your goals through market and economic cycles, typically in the 75% to 90% range. It’s important to note that confidence ranges vary by age and circumstance. For instance, a lower projected success rate may be acceptable for young professionals, because there are several decades over which factors will change, including how much they can save. Retirees should look for a higher projected success rate, given their shorter timeframe and expected income requirements.

You’re missing something important if you are estimating your financial plan’s success based on an average rate of return. What you’re overlooking is the fact that returns fluctuate over time and this fluctuation can have a significant effect on your investment results. Return fluctuations run you the risk of falling short of your investment goals if the market experiences an unforeseen downturn and your portfolio does not have time to recover. Assuming an average rate of return also misses the effect that the sequence of your portfolio’s returns will have on your financial life plan. A sequence of low returns at the outset of retirement, for example, can have a much more profound impact on your plan’s success than the same sequence of low returns toward the end of your retirement. Stock and bond returns are unpredictable; they will vary widely over your planned investment horizon. The reality is that neither you nor anybody else knows what your portfolio returns will be in the future with any certainty.

However, our sophisticated financial planning software incorporates Monte Carlo simulation to provide a better sense of a financial plan’s possible outcomes. These outcomes reflect many different market assumptions to give you and your advisor a sense of what is most likely. This can provide a more realistic investment plan than one that relies on average annual rates of returns alone.

Don’t get me wrong, Monte Carlo simulation is not a guarantee of success. There is no reliable way to predict what markets will do or know whether they were modeled entirely correctly by the Monte Carlo simulation. That said, Monte Carlo simulation is useful to help clear away some of the murkiness in our forever cloudy crystal ball. Also, Monte Carlo tools are not intended to use once and then forget about. As life happens and inputs to your plan change, update the assumptions in your Monte Carlo simulation and reexamine the output. For example, divorce, disability, loss of income or other serious personal financial events will change your financial plan’s probability of success, and you would need to adjust your plan to ensure an acceptable range of outcomes.

Monte Carlo simulation techniques have had a lasting impact on the way we stress test investment plans and measure their resiliency. They give us a way to create and test a financial life plan that considers multiple market scenarios, offering us a glimpse into many possible outcomes. They also give us a tool to help decipher the impact that significant life events have on a plan while providing ample warning to adjust and enhance it. Unfortunately, we can’t control market returns. But we can control important investment and financial plan variables, like spending rates, saving rates and asset allocation, to improve our odds of success. The goal of any investment plan is to succeed, but if you don’t plan properly, you plan to fail.

Written by: Sheldon P. McFarland VP, Strategy & Research, Portfolio Strategy and Research, Loring Ward.

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The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Partners. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

James Yarbrough