A Monte Carlo simulation is a complex mathematical process that estimates the probability of reaching specific goals in the future. This method is often used to determine the probability that your investments will last for a certain number of years during retirement.
The simulation takes into account investment returns, volatility, correlations, inflation rates, and other factors. When making the calculations, thousands or even millions of different scenarios are randomly generated to determine the probability of meeting a specific goal.
Historically, forecasts have been made with straight-line assumptions. For instance, you might calculate how much you can withdraw on an annual basis over 40 years starting with a $1,000,000 portfolio earning 8% annually and 4% inflation. When making the calculation, you would assume that all these factors stay constant from year to year.
In actuality, your investment return and inflation will fluctuate from year to year. Even if the average return is exactly the percentage you estimate, the pattern of those returns and the pattern of your withdrawals can substantially change your answer.
That is where Monte Carlo analysis comes in. It takes your estimates, then generates scenarios providing a range of possible outcomes. It will then tell you the probability that you will reach your goal with the current estimates. If you determine that that probability is too low, you can change some of your variables and rerun the simulation.
While Monte Carlo analysis is often considered a more thorough analysis than straight-line calculations, there are still some concerns you should be aware of:
• As with all types of analyses, the results are sensitive to our assumptions. To ensure that the Monte Carlo analysis is useful, you need to ensure that the assumptions are reasonable and will approximate what you will encounter in real life.
• A Monte Carlo analysis is simply showing the probability that you will achieve your goal. It is often difficult to decide what an acceptable probability is. Should you settle for a minimum of 80% or 90%? What is the practical difference between these two answers? Even with a high probability, there is still a chance you won't reach your goal. If you find yourself in a situation where you run out of money late in life, a high probability will be little comfort.
• This analysis typically assumes you will maintain a level stock exposure, despite how the market is performing. In reality, many investors are tempted to change their stock exposure during periods of significant downtime. That can have a dramatic impact on the probability of achieving your goal.
While it is easy to change variables to obtain a higher probability, make sure your assumptions are reasonable. Often, investors will increase their stock exposure for the analysis, rather than considering increasing savings amounts or spending less.