Search
More About This Website
Content can appear here in your navigation bar, too. You'll be able to put content in this area just as easily as you can edit and add journal entries. See your website manager for more information.
Subscribe
No RSS feeds have been linked to this section.
Login
Powered by Squarespace
« The Richest Man in Town | Main | Ask Yourself One Question: "Do I Feel Lucky?" Well, Do Ya Punk? »
Thursday
Dec132007

Do You Monte Carlo?

What comes to mind when you hear the term "Monte Carlo?"  Perhaps a large hotel in Las Vegas; a nice little car from Chevrolet; or maybe you are reminded of a gambling Mecca on the Mediterranean for the rich and famous where James Bond loved to hang out.  If so, then you are not hanging around financial planners very much.  Monte Carlo analysis is all the rage in financial planning circles, and for good reasons.

Whenever one contemplates one's retirement nest egg, naturally the issue of how long can this nest egg be expected to last will arise.  Will it last at least as long as I will?  In a bygone era, to answer that very important question, a yearly rate of return would be applied to that nest egg, say 8%, and then the nest egg holder was assured that if he would then withdraw less each year, say 5%, he would never run out of money.  This method assumed a constant, linear, yearly return.  One does not have to have much experience with financial markets to know that markets do not act in constant, linear ways.  In the very recent past we have seen the US stock market go both up, and down, to a far greater extent that the long-term average.  The stock market acts quite independently of yearly averages in any one particular year.  Its performance will eventually return to the mean, but it may take a few years for that to happen.  If the market were to enter a multi-year period of losses, as it did in 2001, just as a nest egg holder retires, his previous, linear calculations would not serve him very well.  Thus, the Monte Carlo method of probability calculating came on the scene for financial planning.

As a forecasting tool, Monte Carlo analysis has been around for quite a while.  I am told that the scientists at Oak Ridge used a form of this analysis in an attempt to forecast what might happen when they started splitting those atoms back in the early 1940's.  It has also been used in the fields of economics, chemistry, city planning, military war-gaming, and the programming of slot machines.  Monte Carlo calculations can be thought of as a "kind of simulation that employs random numbers and probability statistics to produce a reliable snapshot of how likely this, that, or an number of outcomes is likely to occur based on inputted variables." (Lee Eisenberg in The Number)  It also has proven useful for predicting what might happen to nest eggs in retirement; more correctly, it can give the probability of what might happen to nest eggs.

Most Monte Carlo calculators used in financial planning incorporate market data from at least 1900, (some use data from even earlier) and then based on a particular portfolio's asset mix of stocks, bonds, and cash, they run hundreds of possible market scenarios to give a probability estimate of how long that portfolio can be expected to last, given a certain yearly withdrawal rate.  Let us suppose that your nest egg is a healthy $500,000.  Let us further assume that your average yearly return in retirement will be 7% and that you would like to withdraw $35,000 per year.  According to one calculator on the web, the probability of your nest egg lasting 30 years is less than 60%.  It could be that your withdrawal rate is too high, and you will need to modify your expectations unless you can get comfortable with those odds.  As I mentioned in an earlier discussion, a great deal of research using this type of analysis indicates that a 4% to 5% withdrawal rate  yields a much higher likelihood that one's nest egg will survive a normal retirement period.

That great Jedi master Yoda, said, "Difficult to see.  Always in motion is the future!"  Monte Carlo analysis will not predict the future for us, but it will provide one more tool as we consider our financial futures.  It will not answer all our questions (but then, who will?), but I believe that it gives us more useful results than the straight-line calculations of the past.

Here are three links to online Monte Carlo calculators.  Each is a little different, but all are easy and interesting to use.  The one provided by Wells Fargo even has a cute little lady to talk you through the inputs.  Maybe, just maybe, they will give you some information that you can use as you flight plan for retirement!

http://www.moneychimp.com/articles/volatility/montecarlo.htm

http://fireseeker.com/

http://www.wellsfargo.retiresecureindex.com/

Fly/Drive safe!

 

PrintView Printer Friendly Version

EmailEmail Article to Friend

References (3)

References allow you to track sources for this article, as well as articles that were written in response to this article.
  • Response
    Response: Vince Malfitano
    Retirementflightplans - Journal - Do You Monte Carlo?
  • Response
    Response: Vince Malfitano
    Retirementflightplans - Journal - Do You Monte Carlo?
  • Response
    Retirementflightplans - Journal - Do You Monte Carlo?

Reader Comments

There are no comments for this journal entry. To create a new comment, use the form below.

PostPost a New Comment

Enter your information below to add a new comment.

My response is on my own website »
Author Email (optional):
Author URL (optional):
Post:
 
Some HTML allowed: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <code> <em> <i> <strike> <strong>