Monte Carlo Analysis and Your FinancesOne of the tools our financial advisors use when creating and reviewing clients’ financial plans is Monte Carlo analysis, which uses mathematical simulation techniques to examine a range of potential outcomes. Because investment returns are variable, Monte Carlo analysis allows our advisors to assess the likelihood of success for meeting a client’s financial goals across a range of possible outcomes.
Where Does the Name Monte Carlo Analysis Come From?
The concept is named for the Monte Carlo area of Monaco, which is famous for its casinos. The randomness of many casino games is reflected in the simulation technique. Beyond personal finance, Monte Carlo simulations are also used in physics, engineering, and mathematics, among other areas. In fact, the method was first used in association with the development of nuclear weapons in the 1940s.
How Does Monte Carlo Analysis Work?
As a part of our financial planning process, we gather information about clients’ financial goals, as well as income, expenses, investment holdings, and other assets. We input this information into financial planning software, which then runs a simulation of hundreds of potential outcomes based on a range of possible annual investment returns. The software then tells us the percentage of those scenarios in which the client’s goal was met. Because nobody can predict the future, the simulation allows us to assess whether a client’s financial trajectory is favorable given a range of investing outcomes.
How Do We Use Monte Carlo Analysis?
The result of the Monte Carlo analysis does not represent a “grade” of a client’s financial situation, but rather serves as a starting point for conversation between our advisors and clients. A higher percentage of successful outcomes from the Monte Carlo analysis signals that a client is likely to meet their goals without making changes to their current lifestyle. On the other hand, a lower percentage would suggest that a client might want to consider taking actions, such as increasing their income or decreasing their expenses, to have more confidence that their financial goals will be met. We run the Monte Carlo simulation at least annually for each client, which lets us see whether a client’s financial picture is improving.