On the surface, Monte Carlo simulations seem to be great illustrative tools for retirees and soon to retirees. A simulation, for example can show how varying spending patterns and varying investment returns are likely to or not to deplete their retirement nest egg.
All too often though it provides ‘false’ security. For starters, it doesn’t consider the sequence of future investment returns has an effect that is at least as important as the ‘average’ of those returns. The result of thousands of iterations Monte Carlo simulators produce can cause clients to believe they’ve considered all the possible financial outcomes they could experience, when in reality the numbers generated may have little relevance to their personal financial situation. Monte Carlo doesn’t measure bear markets well, another potentially BIG PROBLEM. Finally, this type of simulation is not capable of connecting projected investment returns with realistic cash flows.
Relying on Monte Carlo simulations can be dangerous. The method treats the current market not as a starting point but as merely one of all possible environments. For example, it may predict a 20 percent return because the simulation started at a 7 P/E and then doubled. Problem being it may not be relevant if the current 30 P/E is a 30, you are 70-years-old, and concerned about how your portfolio will be affected over the next 10-to-20 years.
A Monte Carlo simulation might predict 17 loss years out of 77 but is unlikely to put even two loss years in a row, let alone three or four, thus missing the present real world pattern. Nor do random distributions even consider the clients’ and/or advisor’s reactions and decisions to short-term volatilities. Another thing, what value can you put on simulations that look at 77 years when you have 20-30 years left?
To compare reality to the simulations, in one study, an astute advisor created 100 different hypothetical portfolios from 1926 forward, and took varying amounts of income from each. Reality was by far worse! Failure occurred much more frequently than what the Monte Carlo simulations indicated, using the same distributions for income.
Another big issue is that Monte Carlo software makes it easy for the advisor and or person doing the input to raise the odds of success by increasing the amount of common stock in the portfolio. Again, a bad idea when the client really needs to avoid withdrawing portfolio funds in down markets. As I cannot say enough “It is always a mistake to spend money from an account that has gone down in value”. It does not make sense to take more risk because a mathematical error was made in the creation of a model that failed because of the way human nature plays into the whole scenario. The decisions that get made along the way will certainly cause ‘something’ different to happen than what the Monte Carlo model illustrated. These Monte Carlo models do not take human emotions into account. It assumes investors will ride out tough times without backing away from negatively performing investments, something few clients do, something few advisors do.
In fact, Monte Carlo makes it impossible to analyze proposed financial strategies accurately because it treats clients’ assets as separate from their required living expenses. The model assumes, again unrealistically that one never makes an unplanned withdrawal from their portfolios. Really!? Over 30 years, or maybe longer? Not realistic.
Furthermore, Monte Carlo oversimplifies complex financial issues. It does not consider income tax bases in portfolio rebalancing and treats cash flow as a constant, disregarding the devastating effects of large variable expenditures when investment returns go negative.
The truth is that we need to recognize that in planning our future, particularly our financial future, there is a lot of ambiguity, as well as variables including risk and volatility. It is better to be less concerned with the probability of success and more concerned with the consequences of failure. The best way I know to deal with uncertainty is minimize it or even eliminate it. You can do this by creating pension income for yourself using Fixed Index Annuities that contractually guarantee income for the rest of your life. For further reading I recommend Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life by Moshe Milevsky and Alexandra Macqueen.