Monte Carlo analysis has been used for decades in a variety of fields. It is absolutely essential to a variety of professions such as nuclear engineering, pharmaceutical testing, and weather forecasting.
Monte Carlo And Weather
When you think about a weather forecast, do you simply ask will it rain or not? You probably don’t. Like most of us you probably want a probability that it will rain tomorrow.
Nearly everybody takes for granted the weather forecast they can easily find on the internet. But behind these forecasts is a very powerful statistical tool and a lot of computing power. This computing power is needed to run the Monte Carlo simulations that take into account hundreds of different variables that can impact the weather.
The basics of Monte Carlo for weather forecasting are this: Thousands of scenarios are run using the different variables that might impact the weather. These variables spin off in different directions in each simulation, guided by a random variable that moves subject to the historical volatility of that variable.
When all of the scenarios are run, the statisticians add up the number of times it rained and divides it by the total number of scenarios. That percentage number is the probability that there will rain.
Monte Carlo For Retirement
The power of Monte Carlo is now available for retirement planning. This is so important because the financial markets are dynamic. Markets gyrate and can be very volatile. So it’s not enough to ask, “Will I run out of money?” We also need to ask what the probability of running out of money is.
When figuring out a person’s retirement situation, it can be useful to use a simple Withdrawal Calculator for Retirement to get a first estimate of where you stand. This is fine, but it’s important to realize that this is just a rough estimate because they usually don’t calculate your taxes each year and don’t take into account a variety of account types.
Holistic Monte Carlo
When we’re really ready to buckle down and get an accurate view of our retirement situation, we want to use planning software that takes into account the tax code, different account types, and uses Monte Carlo analysis.
I have previously shown how Monte Carlo analysis can be used to determine if one can retire early at 55. I used the WealthTrace Financial Planner for this, which takes into account the following:
- Historical volatility of all major asset classes
- Historical correlation among the assets
- Historical rates of return for a variety of investment and asset types
- Federal and state taxes
- Any other income sources such as social security, pensions, part-time jobs, etc.
- Accounts such as Traditional IRAs, 401(k)s, Roth IRAs, 529 plans, annuities, tax-free accounts, and many others.
Below you can see a sample output of the Monte Carlo analysis.
The Monte Carlo simulator generates 1,000 scenarios. In these scenarios every investment has its rate of return changed in every year, based on their past volatility and correlations with other assets in the portfolio. The program then looks at the number of scenarios where the person or people in the plan do not outlive their money and divides it by 1,000 (the total number of scenarios run) in order to find the probability of plan success.
In the example above we see this couple has a 71% probability of plan success. The graph to the right shows the probability of plan success through each year.
Simple calculators without Monte Carlo analysis can be fine for getting a quick estimate of your situation. But for a complete view of how your life in retirement might shake out, you need to see the probability of outliving your money. Otherwise you will never have the total picture.