By Douglas Goldstein, CFP®
What is the best way to plan for the uncertainty of the future? After all, so much can happen that it makes it almost impossible to create a financial plan. Even if you could quantify all the unknowns in your personal life (getting a raise, losing your job, change in family status, etc.), how can you possibly account for market volatility when creating your financial plan?
The answer: use a Monte Carlo simulation.
A Monte Carlo simulation tests large number of scenarios for what might happen. It calculates your odds of success based a projected end value of your portfolio (which you choose), not on average annual returns.
Monte Carlo simulations are the most important tool in your financial plan.
It is a much better tool for measuring the success of your portfolio than average annual returns. Here are two reasons why:
First, past performance is not a guarantee of future returns. Since we all know this axiom, why would make a plan that’s based on looking backwards?
Second, and maybe more importantly, no one wants to be average. To get the average return, you add up all the returns and divide by the number of years. In the timeframe you’re testing, any individual year’s return may be more or less as the average return. And if a particular year is below the average return, that means you may not be able to pay your bills! While average annual returns might seem flashy, they don’t necessarily reflect the reality of any one individual year.
That’s when Monte Carlo simulations come into play.
Instead of using average returns, Monte Carlo simulations test thousands of randomized returns.
A good financial planning program using Monte Carlo will let you enter the target value of your portfolio, your cash flow, and your asset allocation. Then, it creates a random market scenario and analyzes whether, given the set of possible returns, you’ll have enough money to pay your bills. Then it creates another random scenario, and analyzes those numbers too. And then again, and again, and again….
You can test as many models as you like.
Often, Certified Financial Planners will test at least 1000 different models and see what percentages of those trials were successful.
If given all the data, you have a 90% chance of success, chances are you’ll feel comfortable maintaining your status quo in your current investing strategy, asset allocation, and spending. However, if the models show only a 10% success rate in meeting your end-of-plan value, then you will need to make changes in your spending, income, or asset allocation. A good Monte Carlo simulator will let you test individual changes, until you come up with a plan that not only feels comfortable, but is practical to implement.
Monte Carlo gives a sense not for what will happen (since no one can say for sure), but for the odds that something will happen.
Beware of “cookie cutter” financial planning programs available on the internet and instead meet with a Certified Financial Planner who can think through the real uncertainties qualitatively.
To learn more about Monte Carlo simulations and why they are important to use in financial planning watch this 7 minute video I made.
Douglas Goldstein is both a CFP® and an avid chess player. He and Grandmaster & World Chess Champion Susan Polgar are co-authors of Rich As A King: How the Wisdom of Chess Can Make You a Grandmaster of Investing; www.richasaking.com. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, SIFMA, FSI.