Monte Carlo Simulation (MCS) is one the most powerful analytical tools in my financial planning toolbox. MCS sounds like gambling, and in a way it is, because this system harnesses the power of probability to predict your financial future.
Here’s how MCS works. As with all financial planning, I help you establish where you are right now. Then you decide where you want to be at, say, retirement. From there we determine how to get from point A to point B.
MCS takes your data and runs the equivalent of 10,000 trials, in effect rolling the dice for each year between now and your retirement. The simulations try to account for all possible ups and downs in the market. The results, expressed as a percentage, make up your retirement sustainability—the probability that you will be able to fully fund all of your retirement goals.
If the odds of achieving your investment return are not as favorable as you’d like, there are three variables you can change:
- You can move your retirement age farther into the future
- You can step up your savings rate
- You can reduce your desired spending rate in retirement
With these variables adjusted, I can run the simulations again and see if the odds of achieving your investment return have improved.
Planning for Retirement at Any Age
If your retirement is at least 15 years away, MCS will give you an education in how small changes at the starting line can have a huge impact at the finish. MCS will keep rolling the dice and show you how you’re doing relative to your ultimate goals.
If your retirement is less than five years away, or if you’re already retired, MCS takes on a somewhat different role. With a shorter time span to work with, the simulations become more accurate. You can also realistically separate your goals into necessary and discretionary rather than combining them all into a single retirement goal.
The simulations will show you which if any of your discretionary goals are at risk. MCS will also show you something even more important—which of your goals are not at risk. Not being able to spend a month in Italy every year is not the same as not being able to meet your basic living expenses! With this information in hand, we can take steps to shore up your plan and get your threatened goals back on track.
Think of MCS as a generator for “What if?” scenarios tailored to your financial situation. With this terrific tool on our side, we can plot the best way forward for the best possible financial outcome.