THE MONTE CARLO EDGE
In recent years, Monte Carlo simulations have become
popular in financial circles as a tool to illustrate
the possible effectiveness of financial plans in meeting
retirement goals. They are particularly useful in
displaying the probabilities of a person’s money
lasting his or her lifetime at different rates of
withdrawal.
Developed at Los Alamos in the late 1940’s,
Monte Carlo simulations were created to show the range
of possible nuclear explosion results. The name was
drawn from the casinos and games of chance in Monte
Carlo. Adapted for use in investments, a Monte Carlo
simulation runs hundreds or thousands of combinations
of market returns, taking into account the unpredictability
and volatility of the financial markets. It then calculates
the probability that your money will not be depleted
too soon. Financial advisors typically input information
such as your age, income needs, account value, risk
tolerance, along with assumptions regarding your life
span and inflation to arrive at an estimate of your
possibility of success. Returns and probabilities
generated by Monte Carlo simulation are based on historical
and hypothetical information; there is no guarantee
that actual future results will perform in accordance
with the probability assessment.
The simulations are not perfect but they are more
reliable than using the linear averages of investment
returns. Using an average rate of return to gauge
your withdrawal amounts could be risky if returns
drop dramatically below the market historical average
returns. When money is withdrawn during a down market,
your principal is reduced and you would need a higher
rate of return to recoup your losses and maintain
your level of withdrawals.
In addition, keep in mind the following drawbacks
to Monte Carlo simulations:
- Simulations can be misleading if they are too
optimistic or pessimistic.
- There is disagreement over how many simulations
are necessary to provide an accurate assessment.
- The use of random numbers will not replicate
the way markets actually behave since they cannot
account for the human emotions that sometimes drive
the financial markets.
With these drawbacks in mind, Monte Carlo simulations
are effective tools when determining proper asset
allocation and diversification while incorporating
such investments as annuities with individual stocks
and bonds or separately managed portfolios. Long term
historical average returns are useful in this context
in providing perspective.
by Dexter S. Aoki, Chief Investment Officer
