Investment portfolios are a major part of any financial plan. Their many functions include; preparing for retirement and providing funds to live on in an investor’s golden years, saving for long-term goals, increasing wealth, providing funds for charitable giving, serving as a legacy for succeeding generations, and more.
It goes without saying that investors want their investment portfolios to perform well. But what’s the best method of optimizing performance?
The truth is there is no one best method because many variables go into investment portfolios; including, asset class choices and the weight of each asset class in a given portfolio, individual choices within the asset class, an investor’s risk-reward profile and risk tolerance, general market conditions, and overall economic conditions. In addition, each portfolio is affected by the time span in which it is held, inflation rates, tax considerations, and other factors, such as global events.
However, there is a method that San Antonio financial advisors deploy to utilize these variables on the road to optimizing your portfolio’s performance. It’s called Monte Carlo simulation.
What Is Monte Carlo Simulation?
A Monte Carlo simulation is an analytic computer model of multiple factors that provides a range of potential outcomes for a future goal. It’s driven by intensive data analysis.
Let’s say, for example, that you want to know how much money to save for a comfortable retirement at 67. A Monte Carlo simulation can provide you with a range of potential results for use in San Antonio, Texas financial planning. It can compare and analyze your retirement savings rates, probable inflation rates, returns on multiple asset classes, tax scenarios, age at retirement, expected withdrawal from retirement plans during your golden year, and your expected life span.
In other words, your financial advisor can run multiple Monte Carlo simulations that use variable savings per year for 30 years invested in a portfolio comprised of stocks, bonds, and cash, with stocks forming the preponderance. Once you reach retirement age, how much are you likely to have in your retirement portfolio under each scenario? (For example, if you save $5,000, $10,000, or $15,000 per year – the list can be nearly endless.) What is your tax situation likely to be? How much can you withdraw to live comfortably each year? How much will inflation have affected your portfolio’s purchasing power over that period? What should your portfolio allocation be at retirement? During retirement?
Monte Carlo analysis can provide multiple scenarios to help you plan, using multiple inputs. These simulations can provide a much more comprehensive set of probabilities than simply assuming a general rate of return.
Many financial advisors, for example, assume an average rate of annual return for an asset class, such as stocks. That average includes expectable downturns. These assumptions can be helpful in establishing the likely growth of a portfolio. The U.S. stock market as measured by the Standard & Poor’s 500, for instance, has returned an average of 10 percent over the past 100 years, even factoring in periodic bear markets (downturns of 20 percent or more in a year). But ultimately, that is just one scenario, based on the historical record. A Monte Carlo simulation offers a broader and more nuanced picture, which is helpful because past performance is never a predictor of future performance. A Monte Carlo simulation can provide a forecast for every savings rate and rate of return over every time span you and your financial advisor want to see.
In addition, forecasts with a Monte Carlo simulation can factor in a much broader set of outputs, such as contributions to your retirement plan, time to retirement, projected time in retirement (your life span), spending in retirement, taxation’s effect, inflation’s effect, and multiple economic scenarios.
The Benefits of Monte Carlo Simulations
The benefits of Monte Carlo simulation are that it provides hypothetical scenarios for many different inputs. What if you were to save $5,000 for 20 years? Save $6,000 for 15? What if your retirement portfolio was invested in high-return, high-risk stocks? What if it was invested primarily in bonds and cash, which have less of a return but are more stable in price? What if you wanted to retire at 50 rather than 67?
A Monte Carlo simulation can also be used to run scenarios for your finances in retirement. Most people, of course, withdraw from their retirement funds for living expenses in retirement. Your financial advisor can help you determine a percentage to withdraw that will keep your retirement funds fairly stable. (If, for example, your retirement portfolios return an average of 8 percent per year, you can withdraw from 4 percent to 6 percent per year and keep the principal stable and earning.) But what if you could withdraw more with little risk to your portfolios?
For that matter, how do you know if market conditions are such that you should withdraw less for stability, as can happen in a market downturn? You won’t necessarily know of a market downturn in advance. A Monte Carlo simulation can help you and your financial advisor manage risk with multiple scenarios.
Ultimately, a Monte Carlo simulation helps you manage risk and reward more effectively. You can use the multiple scenarios to assess whether to hold the course with your current asset class allocation and specific chosen assets, or whether to change them – and in what direction
(higher reward investments that carry more risk or more stable investments with a comparatively lower rate of return).
Monte Carlo simulations also help you assess whether your own plans are on the right track or whether a change might be doable or advisable. Do you have enough saved to retire early? Will you be able to meet your goals? What if high inflation should hit? What if taxes rise? All these questions can have a potential answer using Monte Carlo simulations.
The Applicability of Monte Carlo Simulations
While we’ve used retirement portfolios as our example, the principles and benefits of Monte Carlo simulations can be used to achieve any of your goals and objectives obtained by investment portfolios.
PAX Financial Group
At PAX Financial Group, we are fiduciary financial advisors in Texas who match your goals with strategies for your investment portfolio. We will work with Monte Carlo simulation and investing as elements of a comprehensive financial plan to meet your needs. We are happy to talk by phone or in our convenient San Antonio office. Contact us to discuss your comprehensive financial planning needs.
