Monte Carlo simulations have applications in a wide range of industries, but they are particularly useful in financial planning. Clients need to know how long their money will last and the impact that market conditions will have on their savings and distribution. Advisors most often use geometric means and straight-line analysis, which are both important for linear projections, but these calculations don’t tell the client’s whole story.
Monte Carlo simulations can give clients a greater sense of security with their financial plan and confidence that they’ll achieve their financial goals.
What Is Monte Carlo Analysis for Financial Planning?
Monte Carlo simulations are statistical simulations that model the probability of different outcomes in a process that can’t be easily predicted due to the intervention of random variables. In other words, it’s used to measure the overall probability of success of a financial plan.
Monte Carlo analysis subjects a client’s plan to a number of market conditions, sometimes in excess of one thousand different scenarios, to account for fluctuations and volatility in the market that other calculations don’t take into account.
This is a valuable tool for financial advisors. Nobody can predict the swings of the market with perfect accuracy, and market changes can significantly impact a client’s financial plan.
How Is Monte Carlo Calculated?
Monte Carlo analysis relates to the law of large numbers—essentially that a larger number of trials creates a more accurate average. A coin being tossed four times may not be close to a 50 percent heads and tails outcome, but a coin that’s tossed one thousand times will likely be much closer to the expected 50 percent.
There are two important calculations at the heart of a Monte Carlo analysis:
- Correlation: the relationship between variables in which the behavior of one impacts the behavior of another
- Standard deviation: a numerical measure of volatility or risk used to determine the spread of potential outcomes
The actual calculation of a Monte Carlo simulation depends on the tool being used. It can also get quite in-depth, especially for something as large and complex as the marketplace.
At a high level, Monte Carlo in financial planning is calculated through the creation of a correlation matrix. This matrix plots a vast number of market variables on X and Y axes, then assigns a numerical value to the relationship, or correlation, between each market variable. The data on these relationships is used to influence the returns that are seen when running Monte Carlo simulations.
The standard deviation of these results is calculated, giving the overall Monte Carlo output an upside, downside, and median outcome. These values represent the best, worst, and most likely outcomes of a financial plan, respectively, given a large number of different market conditions.
Why Use Monte Carlo Simulations for a Client’s Financial Plan?
Monte Carlo outputs better account for market volatility by using correlation and standard deviation calculations to treat each year as an independent event. Linear growth projections depend on geometric means, which take into account previous years’ performance on future returns, to show static growth rates. These calculations don’t consider a range of possible outcomes. When clients want to know how long their money will last, Monte Carlo analyses that account for market volatility will offer more accurate insight into how real-world market conditions will affect a client’s finances.
Beyond the accuracy of financial plans, however, is the fact that Monte Carlo simulations can give clients a valuable sense of financial security. When clients know their plan has been tested in over a thousand different market conditions, they can rest easy knowing their finances are secure and that they’re on track to reach their most important goals in life. They can feel that their financial situation is in good hands—that their advisor is not only capable, but also dedicated to acting in their best interest.
Give Clients a Sense of Security with Monte Carlo Simulations
Monte Carlo analysis is a highly valuable tool for financial advisors, allowing them to account for unpredictable fluctuations and market volatility.
These simulations can provide clients with more certainty in an uncertain world. Securing confidence in the value and accuracy of a financial plan can be a major step towards establishing long-term, productive relationships with clients.
Monte Carlo analysis is an advanced financial planning technique that can help demonstrate complex, real-world scenarios over the client’s entire lifetime. To learn more about in-depth planning techniques, check out Advanced Planning from eMoney and see how you can provide comprehensive planning solutions for your clients.