Monte Carlo simulation a questionable planning tool?

Monte Carlo simulation is a popular tool used by advisors to provide clients with an estimate of the odds of reaching financial goals in the future, such as retirement. It is good for helping advisors demonstrate the ups and downs of the market to their clients, but because it failed to predict the market downturn that hit in late 2008 the validity of Monte Carlo is being questioned for its ability to quantify risks.

Joel P. Bruckenstein’s article entitled What Are The Odds? published in this month’s Financial Advisor Magazine examines how  Monte Carlo implicates financial planning.

“The consensus among advisors, software developers, and other experts,” writes Bruckenstein, “is that there is nothing fundamentally wrong with Monte Carlo models.”

EISI’s Dr. Linda Strachan, Sr VP, Product Marketing, was interviewed for the article. “They are not perfect but they are far better than the straight-line and deterministic models that have been used in the past.”

Monte Carlo simulation is an algorithm that uses repeated random sampling to estimate risk when it is impossible to calculate an exact result, similar to the activities of a casino, Bruckenstein points out.

Bruckenstein proposes three key variables that must be considered when using Monte Carlo in financial planning: “the quality of the model being employed, the quality of the inputs, and the way the results are conveyed to clients.”

Not all Monte Carlo engines built for financial planning software are created equal, he says. “For example, some engines are tax aware, while others take into account no tax consequences whatsoever.”

Another criticism is that the inputs and assumptions built into many Monte Carlo tools use a normal bell-shaped distribution that ultimately generates too few negative scenarios and success rates that are too high. However; neither Monte Carlo tools nor financial planning software is entirely to blame.

As noted by a number of industry experts and advisors quoted by Bruckenstein, a bigger problem with using Monte Carlo as a planning tool is the way its information is presented to clients.

“Monte Carlo simulations, used in conjunction with other planning tools and techniques, offer the best planning outcomes,” Strachan says. For this reason, EISI has incorporated the ability for advisors to conduct stress tests on the plans they create with NaviPlan software, which means they can show clients how they will be impacted in the event the market tanks.

Read more of Bruckenstein’s examination of Monte Carlo simulation at FinancialAdvisorMagazine.com.