The Formula One of financial planning

For many people, say the words “Monte Carlo” and visions of an overseas trip, sipping champagne while sashaying through a casino after playing a few hands of blackjack, and perhaps a very long car race come to mind. For those in the financial world, the words “Monte Carlo” refer to a report that looks a little like a bunch of tiny footed mice wandered from one side of the page to the other. Perhaps still some casino aspects but far less sashaying.

The Monte Carlo (MC) Simulation is a mathematical simulation invented by John von Neumann and Stanislaw Ulam during World War II to help improve decision making under uncertain conditions (which includes essentially all military events). Based on a variety of sets of data, the formula runs lots and lots of possibilities then illustrates which scenarios have what probability of success. Von Neumann and Ulam were inspired by the game of roulette and decided to name the program after the casino town in Monaco with the same name.

An MC simulation charts the probability of certain financial outcomes at certain times in the future by generating up to 10,000 possible economic scenarios that impact the performance of your investments (and that’s the boiled down mouthful….). The variables used are mainly different rates of return on the assets in someone’s portfolio as well as how each type of asset might react during periods of volatility. Assets like CDs and savings accounts are less likely to have volatility whereas stocks and stock-based investments are more likely to experience up and down swings. It will also often make some assumptions on your asset allocation as you age and include any sources of income you either receive or could expect to receive. Overall, the results allow investors and planners to see what the impact of those inputs have on a given outcome and what, if any, relationship there is between the different variables being used.

Some of those 10,000 scenarios assume favorable financial market returns, consistent with some of the best periods in investing history. Others assume unfavorable financial market returns, consistent with some of the worst periods in investing history. Most scenarios will fall somewhere in between. The mouse tracks on your report will represent only a few of the many possible outcomes.  The report will also categorize the results of all of the scenarios. The “Minimum” percentage represents the lowest return of all the scenarios run, which will include those where the assets ran out prior to life expectancy. “Average” is exactly that – an average of all the scenarios. “Maximum” is essentially the opposite of “Minimum” and represents the highest accumulation of the scenarios.

The report may also give you a recap of the percentage of times your situation is successful. For example, a Monte Carlo report might show that you have “Percentage of results above 0% = 55%” and then a couple of line items that show you have “Percentage (of results) with $ remaining at Jane’s age 87 = 97%” or “Percentage with $ remaining at Jane’s age 92 = 82%.” Obviously, the higher the percentage the more successful you are likely to be for a retirement based on the information provided.

Which is all great as long as life doesn’t get in the way. One of the reasons we call financial planning a living process, and the handouts we give you “living documents,” is because life does happen. A Monte Carlo simulation has no way of incorporating the unexpected arrival of your child (and their children) on your doorstep after a marriage collapses. It also doesn’t incorporate the impact of tapping your retirement resources in a way that results in you paying a Medicare surcharge two years down the road since the data points don’t include any variance in the tax rates or brackets. It doesn’t include any unscheduled cash flow tapping, regardless of the reason or portfolio impact. Another factor not included. Inflation. And I think we can all speak to how that has felt over the last couple of years.

Remember – if you are running a Monte Carlo on one of the many, many programs out there, it is just one tool in a planning toolbox. It can provide you with some information (a likelihood of success) but, as with any planning tool, it doesn’t tell the whole story. One of the best ways to learn the whole story is to look in the mirror. The person looking back will often provide you with just as much information as any computer program. The difference is that you have to actually listen to the person in the mirror and many of us don’t always do that.