Understanding Monte Carlo
Monte Carlo simulations perform a risk analysis on your portfolio.
Many simple retirement planning calculators can provide you with a picture of your financial future. Their results are based on factors such as the value of your investments, your life expectancy and the rate of return on your investments.
- Often their calculations assume that you will earn exactly the same rate of return on your investments every year. But that never happens.
- A more accurate picture can be painted if the variability of the returns on your investments is considered.
- A Monte Carlo simulation samples many different random rates of return over a number of years. It then creates a level of probability on what your plan will achieve.
As an example a simple calculator may show that you have exactly enough money to retire and cover your living expenses until age 90. In that same situation, a Monte Carlo simulation may show that you have a 50% chance of not having enough money to fund your retirement and a 50% chance of having excess money at age 90.
- Some financial plans suggest a 70% threshold as a benchmark for a successful solution. Others suggest a 66% threshold provides a reasonable margin of safety.
- According to an article appearing in www.dailyworth.com, “the objective is not to achieve 100-percent probability of success, as you may have to sacrifice your current lifestyle goals unnecessarily… Monte Carlo analysis helps us prioritize how we can best spend, save and share our hard-earned capital.”
- Read the Daily Worth article here.
While a Monte Carlo simulation measures the probability of success it does not measure any potential shortfall or surplus.
- When one of the random possibilities generated misses your target by even $1 it is considered a failure. Your simulation could have several possibilities that miss by only a small amount.
- For that reason you should use the Monte Carlo simulation along with the amount of an estimated average surplus or shortfall to determine the whether your retirement is financially viable.
Each financial planning program that uses Monte Carlo simulations has their own approach.
- Some require you to input each of your individual investments into the program. If some investments have a short history, the accuracy of the data may be suspect.
- Some use a limited number of iterations. These are repeated calculation of projections using random rates of return to create probabilities. Those that use less than 100 iterations have a greater margin for error.
There are a number ways in which to apply a Monte Carlo situation to your financial situation.
MoneyPages has concentrated on what we believe is the key issue, the volatility or variability of return on your investments.
- We use a Monte Carlo simulation based on the estimated variability of returns for five different categories of investors. This variability was determined by examining five different model portfolios and their performance over the past ten years.
- Each portfolio undergoes 1,000 iterations of performance to determine your probability of success.
These results are integrated with your other sources of income such as the Canada Pension Plan, Old Age Security and employer pension plans. Together these factors provide you with a comprehensive picture of your retirement.
Every user has to be comfortable with their own choices. By trying a few different scenarios, you can compare various results, each with its probability of success along with an average shortfall or surplus. This can help you understand your options and to see the impact of any choices you make if you modify your plan.
If you require a more detailed risk analysis you can refer to financial plans such as FP Solutions and Naviplan. These can be prepared for you by Certified Financial Planners.
Disclaimer: The Monte Carlo simulations and probabilities of success created by MoneyPages are for illustrative purposes only and results produced by a Monte Carlo simulation may vary with use and over time.
MoneyPages makes no claim as to the accuracy of these projections. The projections produced are hypothetical in nature and do not reflect actual investment results nor do they guarantee future results.
Any investment decision based on the results of these projections should be discussed with the appropriate financial professionals before implementing any change to your investment strategy.Investing involves risk including the potential loss of principal. No investment strategy, including diversification, asset allocation and rebalancing, can guarantee a profit or protect against loss.