Why a Monte Carlo Analysis Is Not a Financial Plan

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Questions answered:

What is a Monte Carlo Analysis and what is it used for?
How does a Monte Carlo Analysis work?
Why is it an important part of a financial plan?
What role does it play in financial planning for retirement?

Key Takeaways:

What is a Monte Carlo Analysis?
- A Monte Carlo Analysis is model used to predict the probability of different outcomes when there are random variables involved. In other words, it tells you what your probability of having a successful retirement outcome is.
- It does NOT tell you what you need to do to reach your retirement goals or if you’re taking the right actions to get those great outcomes.
Financial plans
- The goal of a financial plan is to tell you what specific, direct actions you can take throughout your life so that you can have your ideal retirement.
- Financial plans help you answer questions like: Are there better paths I can take? Are there shortcuts I can use to reach my goals faster? Are there times when I should stop and “enjoy the view”?
How Monte Carlo Analyses work
- Monte Carlo Analyses use data like what you want to spend each year in retirement, how much you’re saving, the return rates on your investments, what your financial plan looks like, etc., generating thousands of random outcome simulations, giving you best-case and worst-case scenarios of what your future could look like.
- Your financial planner may tell you that if your Monte Carlo Analysis shows 85% chance of success or higher, you’re in the confident zone, meaning you’re probably going to have a financially abundant retirement. If you’re in the 70-85% range, it’s a bit iffy, meaning you might be okay and you might not be. If you’re under 70%, you probably need work with your financial planner to change your plan.
The Problem
- If you’re relying on a Monte Carlo Analysis, especially if you’re an investor, you really won’t have a good idea of how to best manage your portfolio, your savings, and the rest of your finances.
- If you don’t have a written plan with what to do with your capital and your investments, the Monte Carlo Analysis will not be helpful.
Benefits of a Monte Carlo Analysis
- Once you have a roadmap, or your financial plan, it gives you an approximation of whether you’re on track to reach your financial goals for retirement.
- It lets you know whether you’re spending way too much or spending way too little. If you have a 100% chance of success, you know you’re being way to conservative with your spending or planning and you have more than enough assets to generate success (however your plan defines that), even if you hit bumps in the road (like stocks crashing).
- It gives you an understanding of the uncertainty of investing. Although we can make reasonable assumptions about what we think is going to happen to your investments, we can never know for sure what the stock market is going to do.
Disadvantages of a Monte Carlo Analysis
- Just because you’re at 100% chance of success, doesn’t mean you’re making the best possibly choices and that everything is optimized for your situation.
- They do not show you the specific path from point A (the present) to point B (retirement).
- It does not show you the potential magnitude of failure.
- It doesn’t give you peace of mind!
Summary
- A Monte Carlo Analysis is not a substitute for a financial plan. A financial plan tells you how much you can confidently spend, where income will come from in retirement, how you will protect yourself against the risks of healthcare, long-term care, and death, how to save the most money in taxes over the course of your retirement, how to best allocate your assets to support your goals, and most importantly, how to live your best life.
- The goal is not to have the highest Monte Carlo Analysis score. The sign of a great financial plan is a life well-lived and a life lived with intention.