Monte Carlo Simulation

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Hi, this is Dave Zaegel.

Let’s talk about Monte Carlo Simulations.

You may be wondering what in the world is a Monte Carlo Simulation?

What does it have to do with anything business or finance related?

Well, Monte Carlo Simulations sounds fancy, and in some ways it is, but really when you break it down into layman’s terms, it’s a probability analysis.

And it uses random variables to figure out the probability of various events happening.

Again, that’s a very layman’s terms explanation, but it’s all you really need to know for Monte Carlo Simulation unless you’re really getting into the details and you’re going into a scientific field, where this is often used.

So Monte Carlo Simulation is heavily, heavily used in science and engineering because they really need to know the probability of a random set of variables and how that impacts their calculations.

It’s also crept into the use and the field of finance, and specifically financial planning.

You’ll especially hear this a lot when talking about retirement planning, because if you are nearing retirement especially, and you want to look at the probability of a successful retirement, well there’s a lot of random variables that will go into that.

You could look at different tax rates, you could look at different outcomes in the Stock Market and Bond Market and just a lot of different inputs that are variable and that will impact the future of your investments over time.

What happens often times is this word Monte Carlo Simulations or Monte Carlo Analysis gets thrown around and it sounds fancy and everybody goes, “Oh, Monte Carlo Simulation.”

When really if you just break it down for what it is, it’s a probability analysis.

This used to be done a lot using Excel and it might have taken awhile to build out Monte Carlo models.

Now there’s add-ins in Excel that make it a lot easier, but really a lot of the financial planning software has this built in already.

So oftentimes, I hear people say, “Oh, we’re running a Monte Carlo Simulation”, and they try to make it sound fancier than it is, when really the software’s developing the simulation.

They don’t necessarily know how to calculate it.

And that’s okay.

They don’t need to know how to calculate it.

But I feel like a lot of people hear Monte Carlo Simulation and they think, wow this must be amazing, whereas really it’s pretty standard in the retirement planning space.

You should be running a Monte Carlo Simulation to figure out the likelihood of your retirement success.

And again, that tends to be built into the financial planning software that a planner would be using.

So I hope that helps at least break down and demystify what a Monte Carlo Simulation is and that’s it not necessarily as fancy as it sounds, especially in the financial planning world.

Let’s try to keep this simple so that way when we use complex terms like this we understand that really we’re talking about retirement dollars, looking at many different simulations with random events happening and in those simulations, how likely are we to accomplish our goal that we want to accomplish in retirement, knowing what we know and knowing the various inputs that we have to plan for.

And I’ll say one more thing: it’s important to note that if in the Monte Carlo Simulation there’s, let’s say, a percent chance of you achieving your retirement goal out of this analysis, that’s not the end of the world.

You’re still going to have something in retirement and you may very well achieve the retirement goal it’s just that you can’t say for sure that you will.

So it’s not the end of the world if you don’t have percent guaranteed Monte Carlo Simulation retirement goal met.

It’s okay to be a little bit under that and to work towards that over time, versus in the science world if something doesn’t come out much closer to percent it might not be so desirable.

Let’s say you’re an engineer trying to build something.

If you’re building a building or a bridge and there’s even a point one percent chance of failure well, that’s completely unacceptable.

In retirement planning, if you a . percent chance of success, that’s phenomenal.

So, we have to keep this in a little bit of perspective and realize that, even if we’re not at percent odds of achieving our retirement goal, that’s still okay.

There are things that we can change along the way.

Different levers to pull and make sure that you get there.

So don’t freak out if you’re not percent on the Monte Carlo Simulation.

It’s just a probability analysis.

It’s a guide for us going forward.

I hope this helps.

If you have any questions on this, please feel free to reach out to me or leave a comment below.

Thank you.

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