"Monte Carlo" Models Simulate All Kinds of Scenarios
By Christopher Farrell
"What will your portfolio be worth when you stop working? Financial planners usually answer the question by taking a current portfolio, making an estimate of future savings, and - most important - plugging in a long-term interest rate of return on those assets. Problem is, this widespread method relies on average returns.
"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 goals through a 'Monte Carlo' simulation. Monte Carlo simulation is a mathematical model for computing the odds or probability of an outcome, such as value of your nest egg at retirement, by testing thousands upon thousands of possible results.
'"What traditional planning ignores is the timing of the returns,' says Joel Goldhirsh, principal at the financial planning firm Goldhirsh & Goldhirsh in Irvine, CA. A Monte Carlo analysis would highlight some of the problems that might arise in a down market.
"Says Mose Arye Milevsky, finance professor at York University in Toronto: 'In five years, all financial planning will be Monte Carlo.'
"Monte Carlo simulation is a far more realistic measure of financial
risk and reward than any of the traditional financial planning alternatives.
Even more important, Monte Carlo gets people thinking about investment
and longterm planning in terms of probability rather than certainty. And
once you think through the odds, you can make a smarter calculated bet."
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