This is the first in a series of three posts with a focus on retirment planning.
When I tell clients that we performed a Monte Carlo simulation, they get a weird look in their eyes. Until I get a chance to explain what it is, I sometimes think they think I took their money and went to a casino.
When developing a financial plan, several unchanging assumptions are made on inflation rates, rates of return, and tax rates while the real world environment is unpredictable and constantly changing. Monte Carlo simulation is one way to incorporate unpredictable volatility in the plan by introducing random uncertainty into the assumptions and then projecting the model a large number of times. The set of results from all these changes provides an insight into the trends, patterns, and potential range of outcomes under various broad market conditions.
The simulated level of volatility is represented by standard deviation. This statistical measure is used by the simulation to indicate how dramatically rates of return change year to year. The larger the standard deviation, the greater the magnitude of the random changes in each annual rate of return as it varies above or below the average to simulate volatility.
The financial plans I prepare include a Monte Carlo simulation with 5000 trials. The analysis provides the percentage of those trials where the plan suceeded (that is, we did not run out of money) at key ages such as 65, 75, 85, planned retirement length, and life expectancy. One hundred percent certainty is a lot to ask for. In general, I consider a plan with a Monte Carlo success rate of 80% or better to be realistic.
Always keep in mind that Monte Carlo is a statistical analysis only and is hypotheical in nature. It does not reflect any particular investment nor can it predict the future. It is simply a tool to help understand the potential outcomes.
Next in the series: Retirement Withdrawal Planning
Photo on Flickr by John Wardell (Netinho)
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