Understanding Monte Carlo

By April 22, 2016The Friday Brief
Understanding Monte Carlo

What is it about a glitzy gambling city on the Mediterranean, known as Monte Carlo, that could possibly diminish or eliminate the gamble we often associate with our lifetime-investing and planning? A second question sheds light on the first. Where do you think all that money comes from to buy all the glitz? The gamblers of course. The ‘House’ at Monte Carlo wins ‘bets’ far more often than the folks coming for the entertainment. The odds favor the HOUSE and Monte Carlo is a shining example of a well-managed house.

But even in Monte Carlo, the possibility exists that on any given night, a lucky gambler will put together a huge winning streak capable of ‘breaking’ the house. Seeking to reduce, even eliminate the possibility, these masters of odds–the gaming industry–adopted a statistical technique known today as ‘Monte Carlo Simulation.’ It enables them to continually evaluate the risks that any one or several of their houses could experience a run of bad losses that might potentially exceed their reserves to ‘break’ them.

To many, the stock market seems a lot like gambling. Indeed, it has proven to be so for many who get caught up in bubbles and hot trends only to play right into the hands of the powerful marketing machine that is the financial services industry – a HOUSE of a different color. This ‘house’ is expert in packaging products and training sales teams to capitalize on the latest hot trends – such as the dot coms, real estate and oil & gas limited partnerships, collateralized mortgage obligations, annuities and so forth. Every one of them a sure thing, until they prove themselves to be the huge gambles they really are.

The last item on the list, the annuity, might seem misplaced, but it is perhaps the single worst gamble sold today by the HOUSE. Annuities are pushed on eager buyers by trained salesman/agents who ably reinforce buyers’ beliefs that it was the market that ‘burned’ them, when in fact it was the HOUSE that ably played their emotions. Burned by earlier bad bets on the market, many can be ripe pickings for the HOUSE as trusted insurance companies selling ‘guaranteed safe investments.’ More often than not, the guarantee is really a cloaked gamble that their lifestyle won’t be badly diminished by the certain erosion of inflation on their purchasing power.

So how can we become more like the HOUSE and less like gamblers when facing the uncertainty of the stock market? And once more house-like, how can we minimize the risk that a very bad market could come along to ‘break’ our house?

Enter Monte Carlo

The process of becoming more house-like begins with a comprehensive plan. A financial plan is a framework of resources and goals that are characterized as flows of money in and out along the way. We are reasonably sure of when the flows will occur and how much (adjusted for inflation). But what we cannot know what the markets will be up to when these large flows into or out of our investment pool will ultimately occur. Monte Carlo simulation helps us understand what the impact of this risk and uncertainty can be on our plans better than any other technique available today.

Monte Carlo provides us with a statistically robust simulation of how our plan, with all its cash flows and our portfolio of stocks, bonds and cash will behave over many years through all kinds of market volatility and uncertainty. The simulator runs our lifetime plan through 1,000 randomly generated markets, each constrained as much as possible to simulate real-life market conditions and statistically possible market conditions that have not yet occurred, but may.

But why go to all this trouble? If I can get an excellent return on my money by working with the best advisors, money managers, hedge and other fund managers who steadily beat the market, I shouldn’t have to worry about all this planning and testing stuff – right?

In fact, most investors spend the majority of their time worrying about returns. There are two major problems with this approach. The first is that return by definition is an historical measurement of past results. How often have you read the disclaimer ‘past performance is not a guarantee of future results?’ Turns out, it’s true. How can you set an optimal course for your future when you are looking backward?

The second reason returns alone do not represent a sound investing/planning process is that they can be hugely misleading. It’s wealth that funds goals, not returns. Take a look at the following example in which we ran a hypothetical lifetime plan invested in 60% stocks and 40% cash and bonds through three distinct 38-year periods:

  • Lifetime actual market return 8.5% (1954-1994): Broke at 87!
  • Lifetime actual market return 9.8% (1960-1998): Broke at 90!
  • Lifetime actual market return 7.5% (1940-1978): $2.5 Mil Estate

A focus on returns alone fails to address the single most important risk a life-long plan faces – the Sequence of Market Returns. The timing of market or portfolio returns has a far greater impact on the confidence of a life-long plan than does return. THAT’s WHY WE DO MONTE CARLO. We must know if your plan, with its unique cash flows in and out and the portfolio of cash, bonds, and stocks that funds it, has sufficient statistical confidence of meeting or exceeding every goal you value.

Monte Carlo Simulation exposes the danger of a returns-focused approach. The example below graphically illustrates the weakness of ‘straight-line’ forecasting of returns many years into the future. We intuitively know that market returns are anything but steady and straight, but notice just how crooked they are, even when the average returns are the same!

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© MoneyGuidePro

In this example, we selected 8 trials out of 1,000 where the average returns were between 5% and 5.1%. The red lines represent market conditions that caused the client’s plan to run out of money. The worst trial results in our client running out of money within 9 years, at the age of 69, while the best trial has him leaving $470,000 to his children – All eight trials with a 5 – 5.1% return! Returns don’t matter – its wealth matters. And it’s ongoing oversight and stress-testing using Monte Carlo to ensure confidence that matters.

The statistical robustness of Monte Carlo simulation is well accepted today. The technique is broadly used not only in the gaming and financial industry, but also by insurers, manufacturers, applied sciences, medical, aeronautical, space, and so on. When properly used by financial advisors, Monte Carlo can substantially improve the lives of clients replacing luck or bad luck with House-level odds in their investing and planning.

Call us today to help get your HOUSE in order.

Author Sam Bass Jr.

Sam founded Beacon Wealthcare sixteen years ago. He has thirty two years' experience investing money for his clients. In 2006 he changed the focus of his firm from asset/return to a client/goal-centered and adopted state-of-the-art planning and management systems to deliver the best fully integrated planning service available. Sam holds a BA in English Literature from Hampden-Sydney College, 1975 and an MBA from Wake Forest University, 1981. He concentrated in International Finance, and did research for an International Finance textbook which included a summer at the London School of Economics. He is married to Sharon, a talented pleinAir oil painter, They enjoy being with their three children, their spouses, and five beautiful grandchildren as often as they can. Sam loves Jesus, sailing, cycling, and writing.

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