The Monte Carlo simulator is a necessary tool in creating your personal financial plan. As nothing is guaranteed in the world of investing, it's a good idea to evaluate your chances and probabilities in this unique manner.
Probability as determined by Monte Carlo simulations may be an important element of planning your way to wealth.
One of the challenges financial planners face is how to account for uncertainty. No one knows what will be in a month or two, so how can you plan for your retirement decades away? Instead of relying on certainty, financial planning research is often based on the probability that a given financial strategy may be successful.
Even the most accurate assumptions of an average return or the time that will pass until retirement may not work out. Nothing happens exactly as calculated. Investment returns fluctuate, and the sequence in which investment returns occur can make a huge difference to the size of your portfolio. If returns are higher than average early on in the accumulation phase, your account will be larger than if you began with lower-than-average returns.
The same approach applies to withdrawal rates. How much you can safely withdraw each year and not run out of money depends on investment returns, the inflation rate, and anticipated life expectancy.
To evaluate chances for achieving a particular financial goal, financial planners use a modeling technique called the “Monte Carlo” simulation. The planner enters the desired withdrawal rate, average return, standard deviation, anticipated inflation rate, life expectancy, etc. The program generates thousands of variations of these numbers, each time slightly altering a particular variable, such as the sequence of investment returns or the average rate of return, while keeping the target withdrawal rate the same.
Monte Carlo is not foolproof, however. The assumptions one plugs into the program need to be realistic. And even the most accurate numbers can’t account for an unexpected illness or loss of a job. Monte Carlo is a useful tool that provides the means for developing a reasonable financial strategy.
The simulation results show the level of probability at which a particular withdrawal rate will produce the desired results. For example, you might find that you have a 90% chance of not outliving assets by withdrawing 4% from your portfolio annually-but only a 75% chance if you withdraw 5%. This would be similar to the weather reporter saying the likelihood of rain today is 75%, which might encourage you to take an umbrella. The decision whether to take a particular level of financial risk is ultimately yours.
Since we can’t predict uncertainty, the best we can do is prepare for it. A realistic financial plan based on Monte Carlo simulations is a smart way to plan for life’s uncertainties and to try to map out your way to wealth.
For a discussion on other aspects of financial planning, read Do Rules of Thumb Really Help You Decide When to Retire.
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.