To formulate an effective personal investment strategy, it's useful to determine if your investment portfolio is well positioned to help you achieve your most important financial goals, such as funding a comfortable retirement or bequeathing wealth to your heirs.
These days, sophisticated investors are increasingly turning to Monte Carlo simulation, an advanced financial planning tool, to help them assess their chances of achieving their financial goals. By combining probability theory and advanced mathematics, Monte Carlo simulation essentially acts like a 'stress test? that puts your portfolio through its paces and calculates the probability of reaching your objectives, based on certain assumptions.
"Monte Carlo gives you greater clarity about your potential financial future, which in turn helps you to make smarter, more confident decisions about your money," says Kathy Roeser, ChFC?, CLU, a financial planner with Lincoln Financial Advisors in Chicago.
Factoring In Market Volatility
A Monte Carlo simulation is a significant improvement on traditional financial planning methods, which assume that you?ll earn a steady return on your investments - such as 8% a year - over time.
However, the financial markets typically don't generate the "average" return in any given year. Instead, stocks might post outsized gains for one or more years, followed by a period of lower-than-expected (or even negative) returns. ?Simplistic financial planning assumes your investments will never experience volatility, which is a flawed approach,? Roeser points out.
In fact, market volatility can wreak havoc on your retirement income stream and other financial needs. Just ask those investors who began taking retirement distributions in 2000 and watched the value of their nest eggs plummet as the ensuing bear market compounded their losses.
Monte Carlo simulations factor in the market's potential ups and downs in any given year as well as cash flows in and out of your account. As a result, Monte Carlo calculates thousands of possible returns for your portfolio?giving you an additional resource to evaluate how the value of your investments might rise and fall over the long term.
The program also assesses the likelihood that you may meet your goals based on your asset allocation and other factors. "Monte Carlo is a more real-world approach to financial planning," adds Roeser. ?It tells you if your current investment strategy may be optimal based on your specific needs and a number of possible outcomes.?
In particular, running a Monte Carlo simulation may help you answer two important questions:
- Will my money run out? In light of increasing life expectancies, even affluent investors may have concerns about having enough money to ensure a comfortable retirement. Monte Carlo's modeling process can assess the probability that your portfolio can meet your retirement-spending needs under a wide range of potential investment-return scenarios.
- Will my portfolio reach its target goal? Monte Carlo can help you assess the likelihood that you can preserve a specific portion of your wealth (after meeting your retirement expenses) that you may wish to leave to family members, a favorite charity or elsewhere as part of your legacy.
Keep in mind that the projections or other information generated by Monte Carlo simulations regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
Making Contingency Plans
After running a Monte Carlo simulation with your financial planner, you may find that you have a high probability of reaching your specific goals. However, if the likelihood is slimmer than you?d prefer, Roeser suggests that you consider three strategies that may help you get back on track:
Target a higher rate of return on your investments. If you?re likely to fall short of achieving your goals, you may need to increase your allocation to investments such as stocks that can potentially generate the growth needed to help meet your objectives.
Save more. The more money you can earmark toward your savings, the better off you?ll be. Look for ways to free up cash - such as paying off high-interest credit card debt - that you can then redeploy into your investments.
Modify your goals. If you?re unable to allocate more money into your investments or are unwilling to accept the higher risk that accompanies investing more heavily in stocks, you may wish to consider a more modest retirement lifestyle.
Monte Carlo simulation can't guarantee success in achieving your financial goals because investing involves risk factors that can't be fully eliminated. But it can be a useful tool to help provide you with a more accurate picture of your potential financial future. It can also offer you the information you need to help maximize your chances of reaching your most important goals.
Your financial planner can help you determine if a Monte Carlo simulation is appropriate for you. Together, you can focus on managing your assets and identifying strategies that can help you maximize your financial goals.
Talk to Your Planner About:
- The benefits of running a Monte Carlo simulation on your portfolio.
- The likelihood that you?ll be able to achieve your key financial objectives.
- Strategies for increasing your chances of investment success.