We know from the past several years that the economy and the securities markets can fluctuate, life events happen, and no one can have an accurate crystal ball that will predict the future. However, there are tools San Antonio financial advisors use to help factor in the uncertainty and give you a more accurate picture of your financial future.
One tool that San Antonio CFPs® at PAX Financial Group uses is Monte Carlo simulations. These simulations evaluate the potential outcomes of various financial strategies by simulating different scenarios based on projections for a variety of variables into the future.
In our article, we’ll explain Monte Carlo simulations and examine three different scenarios in which they can assist your financial journey. Whether you’re in the accumulation phase, preparing for retirement, or are already retired and in the preservation and distribution phase, this methodology can impact the accuracy of your financial plan.
Learn more about Core-Satellite Investing!
What is a Monte Carlo Simulation?
At its core, a Monte Carlo simulation is a mathematical technique that uses random variables to simulate a range of potential outcomes. When applied to financial planning, it helps model the possible effects of different economic factors—such as market volatility, inflation, recessions, and interest rates—on your investment results over longer periods.
Rather than providing a single estimate of what your portfolio will look like in the future, Monte Carlo simulations show a range of possibilities, from the best-case scenario to the worst. This allows for more realistic financial planning, especially when uncertainty is a factor over long periods.
For instance, instead of predicting that a core-satellite portfolio will grow at a steady 6% per year, a Monte Carlo simulation could project a 90% chance that your portfolio’s asset allocations will grow by anywhere from 3% to 8%, giving you a better picture of choices that produce potential risks and rewards.
Thinking of selling your business in three to five years? Be sure to download our complimentary guide today!
Now, we’ll look at how Monte Carlo simulations can be applied to three key phases of retirement planning: accumulation, preservation, and distribution.
How important are these simulations? They are the foundation of your retirement plan, and your retirement plan is the foundation of your financial security.
Monte Carlo Simulations During the Accumulation Phase
Suppose you are in your prime earning years (40s and 50s) and actively saving as much as possible for your retirement years. In that case, Monte Carlo simulations are especially helpful in evaluating how different saving and investing strategies can impact your future financial security.
This phase of your financial journey is when you build your wealth, often through savings in retirement accounts like 401(k)s, IRAs, HSAs, and taxable investment accounts.
A financial advisor in San Antonio, TX, can use Monte Carlo simulations to project various scenarios for you at this stage. For example, the advisor could assess the impact of increasing or decreasing your contributions, making more aggressive investments, or adjusting your portfolio to reduce risk as you accumulate a critical mass of assets.
Listen to our podcast, “Unlocking Your Investment Why with Bryan Wing.”
Example: Planning for Growth in Volatile Markets
Let’s say you are 40 and contributing regularly to a 401(k) plan and traditional IRA. You’ve chosen a core-satellite portfolio strategy, where the “core” of your investments is in index funds, and the “satellite” portion involves riskier investments with more upside potential.
Your financial advisor uses Monte Carlo simulations to show how different levels of market volatility could affect your portfolio over the next 25 years. The simulations might reveal that while aggressive investments offer a higher potential for growth, they also increase the likelihood of losses in down years.
By visualizing this range of possibilities, you can decide if you’re comfortable with the level of risk you’re currently taking or if a more conservative approach might help you pursue your long-term financial goals with much less stress.
Monte Carlo Simulations During the Preservation Phase
As you approach retirement—typically three to five years before you plan to stop working—you enter the increasingly conservative preservation phase. In this period, protecting your accumulated wealth becomes a bigger priority.
Your goal should be to shift from focusing purely on growth opportunities and changing to more of a growth and income strategy. Increase your focus on quality. For example, moving to more blue-chip stocks and higher quality bonds. Now is not the time to become too aggressive with your investments. You have too much to lose because your recovery time may be much shorter.
Monte Carlo simulations can assist in this stage by assessing how well your portfolio can weather different economic scenarios, such as recessions or inflation spikes. A retirement planner in San Antonio might use these simulations to recommend shifting more of your investments into less volatile assets, like bonds or dividend-producing stocks, while still keeping some exposure to growth.
Example: Testing the Impact of a Market Downturn
Imagine you’re 60, with plans to retire in five years. Your San Antonio wealth advisor runs a Monte Carlo simulation to evaluate how your portfolio would withstand various market downturns. The simulation shows that while your portfolio could survive moderate market losses, a more severe downturn—such as a 30% drop in the stock market—could delay your retirement plans unless you made major adjustments to your strategy in the short run.
This analysis can help you make key decisions such as increasing your savings over the next few years to create a bigger financial cushion.
Monte Carlo Simulations During the Distribution Phase
Once you’ve retired and the paychecks stop, you enter the critical distribution phase, where your primary concern shifts from growing your wealth to preservation and managing withdrawals in a way that ensures your assets last for the rest of your life – which could be 30 years or more. Here, Monte Carlo simulations are invaluable for analyzing different withdrawal strategies, the timing of Social Security benefits, and projecting how long your savings will last under various conditions.
One of retirees’ biggest fears is outliving their savings, a rapidly rising concern due to increasing longevity – a blessing if you have good health and a curse if you run out of money. A Monte Carlo simulation can help reduce this concern by showing how different withdrawal rates and spending habits might play out over time, factoring in various life expectancies, unexpected, excessive inflation rates, and volatile market conditions.
Example: Creating a Sustainable Withdrawal Strategy
Let’s say you’ve just retired at age 65, with $1 million saved in various retirement accounts. Your financial advisor runs a Monte Carlo simulation to evaluate how different withdrawal rates—3%, 4%, or 5%—would affect your portfolio over the next 30 years.
The simulation reveals that withdrawing 5% annually could result in a high risk of running out of money before age 90, particularly if the securities markets returned less than expected. On the other hand, a 3% withdrawal rate reduces the risk of depleting savings over longer time periods.
With this information, you can make more informed decisions about how much you can safely withdraw each year, enabling you to enjoy your later retirement without worrying about your comfort and financial security.
Why Consider PAX Financial for Your Retirement Planning Needs
At PAX Financial Group, we utilize Monte Carlo simulations to give you a more complete picture of your financial future. We help you plan for both the expected and the unexpected, such as a catastrophic illness. By tailoring strategies that reflect your unique goals and circumstances, we build retirement plans based on data that is based on a range of outcomes.
If you’re ready to take control of your financial future with a personalized approach that factors in every possible outcome, consider working with PAX Financial Group to guide you through each phase of your retirement journey. Connect today.
