What's Monte Carlo Simulation, and Should I Care?
You're meeting with your financial advisor, and she tells you that her firm's analysts expect your portfolio to earn 6% per year, on average, during your retirement. Based on that, you're confident you'll have the resources needed to do all the things you've planned.
But what if you think your advisor's confidence might be misplaced? How could you measure the strength of your spending plan? You could use something called Monte Carlo Simulation ("MCS").
MCS is a statistical tool that makes it possible to account for variability of portfolio returns, as well as the sequence of those returns. While your portfolio might return 6% on average over your retirement, it's unrealistic to assume it will earn exactly 6% every year. Instead, your returns will vary widely from year to year (this is what the standard deviation of your returns measures – their variability).
In a nutshell, MCS models thousands of versions of your portfolio's performance – each with the same average return, and variability of those returns, but with a different sequence of those returns. The result is a number that indicates what percentage of those scenarios were successful. The higher the number, the stronger your plan, and the more confident you can be.
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