Most people associate Monte Carlo with gambling and the lifestyles of the rich and famous. As investors, however, you should be familiar with another meaning.
A "Monte Carlo analysis" can be used to determine if you are on track to retire with dignity or more likely to run out of money and spend your "golden years" destitute and dependent on family or the government for your monthly expenses.
In a Monte Carlo analysis, the computer generates a large number of future return scenarios and computes the statistical likelihood of your portfolio surviving to the end of a designated period. The results of the analysis are heavily dependent on the assumptions, so great care must be taken to make the assumptions as accurate as possible.
The assumptions I use in the Monte Carlo analysis include:
The beginning portfolio value;
The number of years (according to actuarial tables) of life remaining for my client;
Future deposits and withdrawals in retirement;
Inflation rate; and
The distribution of returns for the portfolio selected based on past returns. I use either 83 years of data (which includes the Great Depression) or 50 years of data.
10,000 Retirement Scenarios
The computer generates 10,000 different scenarios of year-by-year returns and calculates the value of the portfolio at the end of each year. The end product is the "portfolio survival rate," which computes the odds of the portfolio surviving. For example, if the portfolio is in negative territory for 1,000 of 10,000 trials, the portfolio survival rate would be 90%. I regard a portfolio survival rate of less than 95% as unacceptable.
You can input your assumptions and obtain a Monte Carlo analysis for your portfolio here. (Full disclosure: The input form was designed, and the reports are generated, by Index Funds Advisors, with whom I am affiliated.)
It's not surprising that most investors have no clearly defined goal for their investments. The financial media and "market- beating" brokers and advisors focus on trying to predict the direction of the markets, picking stock winners, and selecting the next "hot" mutual fund manager. Few investors understand no one has the expertise to engage successfully in any of these activities.
Here's the question I ask every investor: Would you find it helpful to understand how to structure a portfolio that will maximize the possibility of your money lasting longer than you and your surviving spouse or partner, for a given level of risk? I have never had a negative response to that question, but I have also never posed it to an investor who had a clue whether he or she was on the right or wrong path towards achieving that goal.
Running a Monte Carlo analysis is not perfect. It is not predictive since it is based solely on long-term historical data. Nevertheless, it is a lot better than the "wing and prayer" that passes for investing "advice" at the office of your retail broker.