What is Monte Carlo Analysis and How Can It Help Investors?
May 17, 2023 | By Eric Siss, CFP®
In this Insight, we explain Monte Carlo analysis (also commonly called Monte Carlo simulation), how it works, and how it can be a powerful tool when projecting a family’s long-term financial future.
What is Monte Carlo analysis?
Many people’s first association when they hear “Monte Carlo” may be a card game, or, for lucky world travelers, a breathtaking part of Monaco anchored by a legendary casino. In a nod to this historic casino and the probabilities underlying its games of chance, Monte Carlo analysis is also the name of a probability-based analysis for predicting outcomes from uncertain variables.
In the context of financial planning, it can help families evaluate how goals may be achieved given a set of uncertain portfolio returns. When done thoughtfully, Monte Carlo analyses are a powerful tool for analyzing important financial planning questions such as:
When are we on track to retire?
How much do we need to save to be able to purchase our dream home?
How will retiring early affect our income in retirement?
How does Monte Carlo analysis work in financial planning?
A solid financial projection starts with establishing key facts related to a family’s financial life and goals. In short, this means clearly defining all income streams, outflows, and investments. These inputs may then be projected forward considering key long-term variables such as longevity and inflation.
With these basic facts in place, simulations can be run assuming a variety of different annual returns over the defined period. This simulation should account for key portfolio characteristics such as the standard deviation and correlation of its underlying components. Once this initial analysis is in place, other variables such as retirement dates, spending, and projected income growth may be modified to evaluate their impact on a family’s long-term financial trajectory.
The final output of this simulation is commonly reported as a “probability of success,” typically defined as having more than $1 left over at the end of the analyzed period. This is not a college test, and 100% is not always a good thing! In terms of your financial plan, an extremely high success probability may mean that you will not be enjoying your hard-earned assets to their fullest.
Ultimately, the best path forward will depend on personal circumstances, and Monte Carlo analysis should never be interpreted in a vacuum. A 50% success probability may be too low for many families but could be a rational target if the family has the flexibility to adjust income or expenses over time. Since this approach focuses on the probability of having portfolio assets left over, even a couple who scores a 10% probability of success may be just fine in retirement if a majority of their core needs are met by Social Security and pensions, and they were only using their portfolio for supplemental desires.
The common probability of success reporting approach is sometimes criticized as overly binary—in this view, people view the result of the plan as either wholly successful or a complete failure. To address this limitation, a preferable way of interpreting a Monte Carlo simulation’s output is a “probability of adjustment.” Viewing the result this way, one should see the probability as the likelihood that their family will not need to make any lifestyle changes along the course of their plan.
What are some important considerations when employing Monte Carlo analysis?
While Monte Carlo analysis is a powerful tool, it must be employed with a firm understanding of its limitations. First, as with any projection tool, its outputs are only good as its inputs. The financial advisor conducting the analysis must employ realistic assumptions about portfolio rates of return, inflation, and more. A family must also provide the most accurate information possible on their financial circumstances. Being overly conservative or optimistic about initial assumptions can negatively affect the validity of Monte Carlo projections, and even small deviations can compound over long projection periods.
It is also important to note that the starting point of a Monte Carlo analysis period can have a major impact on the final results. For example, consider an individual who had $2 million invested in the S&P 500 at the end of 2021. Their projections would look very different by the end of 2022, following a 22% decline in the market.
Monte Carlo projections are typically very long-term in nature, and it is important to recognize that predicting changing life needs over such long periods of time can be inherently difficult. When asked to consider their future in 10 years, many people tend to forecast only minor changes in their lifestyle. But when asked to reflect on life from 10 years ago, many people find it easier to recognize that the continued evolution of their goals, values, and circumstances would have been hard to predict.
For all of these reasons, financial plans should be revisited often. Each year, one more year of the once uncertain future becomes known, allowing for better projections and the ability to continue making well-informed decisions rooted in current life circumstances.
How can Monte Carlo analysis help build rational confidence in your financial plans?
Monte Carlo analysis is only one tool in an effective financial planning toolbox, not a one-size-fits-all solution. Ultimately, the way you execute financial decisions along the way is what will determine your financial future.
It is easy to find various calculations and other projection tools online, but without vetting the inputs and assumptions underlying these models, they cannot be reliably used to project your long-term financial future. Inaccuracies or unreasonable assumptions are particularly dangerous for an analysis informing long-term financial planning: you could unknowingly follow an unsustainable path for years.
We recommend working with a financial professional who understands your goals, can help create a realistic analysis, and understands how to translate that analysis into a plan that you can execute for years to come. As your needs change over time, a financial advisor can also help navigate the complex emotions and sudden financial changes that come from moments like market downturns, sudden job changes, or unexpected large expenses. While the output of a Monte Carlo analysis is measured in probability of success, the most salient output is actually confidence! And that’s precisely what a financial advisor can help provide.
If you are interested in learning more about how tools like Monte Carlo analysis can inform the development of a financial plan that is tailored to your family’s long-term needs, we welcome you to schedule a free consultation with a Wealthstream financial advisor.