When you think about Monte Carlo, you might conjure images of James Bond sipping a martini in one of the most famous casinos in the world. In the investing world, a Monte Carlo simulation is something completely different. If you’ve heard the team but don’t know what it is or why it matters, read on!
Monte Carlo Simulation, Explained
The short version is that the Monte Carlo simulation is a way of predicting outcomes when you have no idea how things might turn out. Believe it or not, the Monte Carlo simulation was invented all the way back during World War II, and was named with the casino in mind. The reason is because it tries to predict what will happen – to your investments, your project, or anything else that’s hard to plan for – in a world where we really don’t know what’s going to happen.
The gist is that you feed in a few variables – in the investment world, it might be how much money you have, how much you earn on it each year, when you plan to retire, and how long you think you’ll be retired for – and the Monte Carlo simulation spits out the chances of you not running out of money in retirement.
It does this by randomly generating thousands of possible scenarios of how things play out in the years to come. In one scenario, for example, everything might be coming up roses: there’s no major stock market crashes, markets all do reasonably well, and so on. In another example, it might be doom-and-gloom: right after you retire, there’s a major stock crash where markets decline 30%.
Why the Monte Carlo Simulation Matters
The two above examples would have wildly different effects on your retirement nest egg, due to something called sequencing of returns (something I’ve written about in another post). There are also thousands of other possible examples of how markets could play out in the future. The Monte Carlo simulation takes all of these, looks at the variables you put in, and then spits out the % of those scenarios in which you don’t go bankrupt.
In other words, really useful stuff if you’re trying to plan for a retirement where you’re not constantly worried about going running out of cash.
Most people wouldn’t accept any scenario in which they’re less than 90% likely to succeed in their retirement. The exception might be if you know you’ll be receiving an inheritance at some point, or if you’re planning on receiving pension benefits through work or the government. The Monte Carlo simulation usually doesn’t factor those things in (though I’m sure there are versions out there that do).
Where Can I Try it Out?
I’ll give you a couple different links to simulations you can try out. If you’re newer to investing, you might want to start out with a version that’s a little more simplistic and approachable. Vanguard has a great tool that’s intuitive and easy to use; check it out here.
If you’re more advanced, Portfolio Visualizer offers a free simulator that comes with a bunch more bells and whistles than the Vanguard version. Some of the fields are pretty complex, so you may want to stick to the defaults in the cases where you’re not sure what you’re looking at. Nevertheless, this is the tool that I use for my own investment predictions.
Wrapping it Up
Monte Carlo simulations don’t offer a crystal ball; they won’t tell you exactly what’s going to happen in the future. But when used properly, they can give you a strong sense of your financial health, and how you’re doing as you progress toward your retirement goals. They’re a powerful tool in any savvy investor’s toolkit!
