While the conventional financial planning works on certain assumptions on returns, risk, inflation, savings growth etc., in real world these assumptions may or may not hold true. So to depict the real world uncertainty, Monte Carlo simulations are used by Financial Planners. Clearly, Monte Carlo represents an improvement over conventional methods of financial planning.
The Monte Carlo method is used to simulate various sources of uncertainty that affect the value of the instrument, portfolio or investment in question, and to then calculate a representative value given the possible values of the underlying inputs.
A Monte Carlo simulation is a mathematical tool that offers a way to evaluate a retirement portfolio to see if it will last a lifetime. With the help of computer software, a planner can simulate hundreds or thousands of market-condition scenarios and learn the probability that your client’s portfolio would last his expected lifetime.
Now a more sophisticated alternative is working its way into financial planning. Using computer software or a Web-based program, you can calculate the probability of achieving your client’s goals through a ''Monte Carlo'' simulation.
When it comes to financial planning, a Monte Carlo simulation takes into account returns, volatility, correlations and other factors, all based on historical statistical estimates. That's similar to the traditional financial-planning approach.
If your client’s portfolio is run through 1,000 simulations, projecting 1,000 separate retirement scenarios, and it works 800 times, it means there's an 80 percent probability that the portfolio won't run out of money. If 80 percent seems too risky and you'd like to increase the odds to 85 percent or 90 percent, you could tweak the portfolio by adding more money to your investments or taking out less.
Given the unpredictable nature of the stock market, the Monte Carlo method can help financial planners model how a particular portfolio will perform under various market conditions, thus helping them make more informed investment decisions. This approach is especially useful in retirement planning, in which investors try to figure out which savings rates, allocations, market returns, and spending patterns will allow them to make their nest eggs last a lifetime.
Monte Carlo method has become popular with financial planners because it takes into account real-world experiences in a way that other methods that assume a given rate of return don't.
The reason Monte Carlo simulations are being used more frequently, is because they do a better job explaining the potential outcomes versus time-value-of-money calculations, such as future value. Future value will tell you the expected value of a portfolio given its present value, years to grow, potential cash flows, and growth rate. The problem with a future value calculation is that it treats the outcome as certain, while in reality, and especially with the markets, nothing is certain. A Monte Carlo simulation provides a more 'colorful' perspective of the range of potential outcomes given the expected return and volatility of a portfolio.
Fiserv offers powerful financial planning tools designed for use by financial advisors.
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.
|
|