The Odds of Success: Monte Carlo Analysis and Your Portfolio

If there’s one question on every investor’s mind, it’s probably some version of this: “How am I doing so far?” This question is especially relevant when you’re making plans to retire or pursuing other substantial financial goals.

To arrive at relatively reliable answers, we use Monte Carlo Analysis. Don’t let the casino-inspired name fool you. We employ this serious methodology to calculate the odds that any given financial plan will succeed based on a wide range of plausible outcomes, from awful to amazing.

Behind the scenes, Monte Carlo calculations are quite complex. They’re based on inputting a number of factors that reflect your unique circumstances, along with a few broad assumptions. We typically identify and input at least the following particulars:

  • Net worth
  • Sources of income
  • Investment profile (expected rates of return, given your portfolio composition)
  • Debt load
  • Spending goals
  • Inflation rates
  • Life expectancy
  • Legacy goals

The software then runs thousands of iterations that generate a broad range of outcomes you might experience over the next few decades, given your circumstances and depending on how things play out in real life.

In other words, although we cannot know what the future holds, we can use Monte Carlo Analysis to generate relatively reliable responses to questions about your portfolio. For example:

  • What are the odds you’ll be okay under the worst scenarios?
  • How much better off will you be if you receive every lucky break that heads your way?
  • How can you expect to fare as you encounter the typical mixed bag of good news and bad?

The results of your personalized Monte Carlo Analysis should provide you with a realistic picture to consider. Following is a basic illustration of the principle, but keep in mind that we have omitted many important details we’d use in an actual Monte Carlo Analysis. You can’t assume that these results apply to you, even if the scenario resembles your own, because your analysis will depend on your unique set of assumptions and particulars.

A Simple Monte Carlo Illustration

 

Let’s say you’re a single, 55-year-old male, and this is where things stand for you:

  • You’re in good health, with at least an average life expectancy.
  • You’ve got a $1 million investment portfolio in a “typical” 60/40 stock/bond mix.
  • You’ve also got a 401(k) account worth $100,000. You plan to continue contributing $1,500/month, plus a 3% employer match.
  • The rest of your $110,000 annual salary goes to living expenses and discretionary spending.
  • You’ve got a home mortgage, with 10 years left before you pay it off.

Here’s what you’re considering (in today’s dollars, without adjusting for inflation):

  • You’d like to retire at age 65.
  • By then, you estimate your portfolio will be worth about $1.5 million.
  • You’re expecting to spend around $95,000/year in retirement – $27,000 from Social Security, and the rest from your investment portfolio and 401(k) account.
  • By the time you pass away, you’d like to have a balance of around $100,000 left, to serve as a safety net and/or to allow for an inheritance.

After we input these and other assumptions and let the Monte Carlo software run its iterations, we can present results that may look something like this (although, again, your own outcome may vary widely from this general illustration):

                                                         If Your Life Expectancy Is …

If you spend …

70 years old

80 years old

90 years old

$85,500/year

100%

93%

70%

$95,000/year

100%

87%

57%

$104,500/year

100%

79%

45%

 

And/or this:

                                                   If Your Portfolio (Stocks/Bonds) Is a …

If you spend …

70%/30% mix

60%/40% mix

50%/50% mix

$85,500/year

92%

93%

95%

$95,000/year

86%

87%

89%

$104,500/year

79%

79%

79%

Each table shows different odds of “succeeding” with any given financial plan. In this particular illustration, if we stick with the initial assumptions of living to around age 80 and maintaining a 60%/40% stock bond mix in your investment portfolio, you would have about an 87% chance of having at least $100,000 left at the end, as desired. This means there’s a 13% chance you won’t and that adjustments would be necessary at some point in time.

These tables can also give you an idea of what might happen if you spend more or less than planned, live a longer or shorter life, or invest more or less aggressively in your portfolio. For example, we could run “what if scenarios” to see the results if you decided to:

  • Work longer before retiring.
  • Spend less, now or in retirement.
  • Alter your investment portfolio mix.

In an actual Monte Carlo Analysis, we cover a lot more ground – plus, we’re often running the analysis for a couple rather than an individual. Either way, beyond presenting a single “success or failure” percentage point, the analysis also provides a dollar range you’re expected to fall into. These insights can further contribute to creating a realistic financial plan for you and your goals.

During these simulation sessions, we work with you to conduct as many “what if” scenarios as needed to arrive at one best suited to your particular goals and circumstances. That’s the one we adopt as our “plan of record” that we follow until your goals and objectives change or until we arrive at another “plan of record” during a subsequent planning session.  It’s a process that always relevant yet never ending.  And, our experience is that it leads to better decision making and greater peace of mind.

The Caveats: No Guarantees

 

As you might imagine, Monte Carlo Analysis depends heavily on the data. In other words, if we put garbage in – such as unrealistic spending goals or inaccurate portfolio balances – that’s exactly what we’ll get back out.

Time matters too. The further out we go, the more likely you’ll experience lucky breaks and bad outcomes. Your own life may change, for better or worse. So might the markets, or inflation, or tax laws, or other variables. That’s why it’s important to engage in this “what if” planning process periodically.

Bottom Line:

One of the most important things you can do to stay on track and understand your odds of success is to keep the lines of communications open with us as your wealth managers.  Don’t hesitate to reach out to us with your questions and concerns. We’re here to help.

Thanks for taking a look!