Retirement Planning — Monte Carlo Simulation

When we plan for the future, two of the biggest questions that come up are: “What's it going to cost to retire?” and “How do I determine how much is enough?”

For most, the answer to these questions can be found in Monte Carlo! No, not the coastal city of Monaco that’s famous for its casinos and games of chance, but rather a retirement calculator of the same name that helps determine the probability that our investment strategy will work.

Traditionally, retirement planning has been done using static analysis, or a constant rate of return. For example, an individual might project a 4 percent or 5 percent return rate for a retirement model if she wants to be conservative. If she wants to invest aggressively, she might pick 9 percent or 10 percent. When choosing a fixed or static return, the only thing we know for sure is that whatever number we pick will not be correct for every single year. We know that the stock and bond markets do not deliver returns in a consistent, static fashion. Rather, the returns are unpredictable and random. In fact, it's more likely that the market may be up 10 percent in one year, then flat, then down 5 percent and then continue to change every year after that. 

The statistician George Box was fond of saying, “All models are wrong: some models are useful.”

Static analysis can have some application, but Monte Carlo simulation is more useful because, like the games of chance in Monte Carlo, it produces a dynamic, random sampling of possible returns. Instead of picking a constant return, the analysis determines the probability that your resources match your retirement goals. 

The simulation does this by calculating up to 1,000 iterations of return scenarios in the stock and bond markets. Based on your risk tolerance, life expectancy and your planned annual withdrawal rate, the simulation addresses how high or low interest rates, bull or bear markets and high or low inflation might impact your nest egg. Ultimately, there are only three ways to address a shortfall: spend less, work longer or die early. 

Since most people prefer to rule out the third option, stress-testing key variables, such as asset allocation, retirement spending amounts and retirement age, can help you create a strategy with a higher probability of avoiding a shortfall — and being successful in reaching your goals.

If you are looking to try out Monte Carlo for yourself, there are many publicly available online tools that utilize the simulation in the retirement models they create. These tools may be a great primer, but the returns given by these tools may be inflated, particularly in returns projected for fixed income. It is strongly advised that you speak with a financial planner for a more accurate interpretation of the analysis of the Monte Carlo simulation.

Remember: the objective is not to achieve 100-percent probability of success, as you may have to sacrifice your current lifestyle goals unnecessarily. In planning, a target zone of 75 percent to 90 percent probability is the sweet spot. You may still have to make some compromises, but working toward a goal may allow you to enjoy life now and still live comfortably into retirement. Unless money is in unlimited supply (which it is not for most of us!), Monte Carlo analysis helps us prioritize how we can best spend, save and share our hard-earned capital.

Now, who wants to go to Monte Carlo?

Deborah Stavis is a member of the DailyWorth Connect program. Read more about the program here.

The results produced by a Monte Carlo simulation may vary with each use and over time. The projections or other information generated by a Monte Carlo simulation regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.

Investing involves risk including the potential loss of principal. No investment strategy, including diversification, asset allocation and rebalancing, can guarantee a profit or protect against loss.

Securities offered through FSC Securities Corporation, member FINRA/SIPC. Advisory and insurance services offered through Stavis & Cohen Financial, a registered investment advisor not affiliated with FSC Securities Corporation.

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