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J&L Financial Planner's Monte Carlo Analysis

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Monte Carlo Analysis

Figure 1.0 - An Example of a Monte Carlo Analysis

Monte Carlo Analysis

The problem with most financial planning software is they accept a return rate on each of your investments and project your financial future on those rates. The argument is that over a span of years your investments will return that rate "on average." Unfortunately this is an invalid and risky assumption. Investment rates vary from year to year. Sometimes they vary greatly. We cannot accurately predict the return rate on your investments or the inflation rate. Consider the following simple example

You have $1000.00 invested and you expect a 10.0% average yearly return on your investment. In two years your investment will be worth $1210.00.

Now lets assume your same $1000.00 returns -10.00% the first year and +30.00% the second. Your investments after those two years is worth only $1170.00 even though your investment returned "on average" 10.0%.

The above example demonstrates the need for a mechanism to account for the volatility of investment return rates and the variability of inflation. The J&L Financial Planner has chosen to include two alternatives, a Historical Return Analysis and a Monte Carlo Analysis, as that mechanism.

J&L Financial Planner's Monte Carlo Analysis

The following paragraphs outline how the Monte Carlo Analysis is implemented by the J&L Financial Planner.

The J&L Financial Planner allows you to create simple or complex financial planning scenarios (financial plans) revolving around your existing accounts, consisting of investment, retirement, asset, and equity accounts. You assign a nominal return rate to each account, the traditional expected average yearly rate of return, as well as a minimum expected rate, a maximum expected rate and an optional Standard Deviation. This minimum rate to maximum rate defines a range for each account which is used by one the Monte Carlo Analysis options. As another option the Monte Carlo Analysis uses the supplied Standard Deviation.

The J&L Financial Planner also gives you the option to collect accounts into groups of accounts. Each group of accounts is assigned a minimum expected rate and a maximum expected rate. This minimum rate to maximum rate defines a range for each group of accounts which is used by the Monte Carlo Analysis as its third option.

The J&L Financial Planner allows you to assign a range of inflation rates used by the Monte Carlo Analysis.

As shown in Figure 1.0 the Monte Carlo Analysis allows you to execute your financial plan up to 1000 times. Each gray graph is a separate execution of your scenario. Each time it is executed the analysis generates a random rate for each of your accounts or group of accounts each year of your plan. The rates are generated within the range of rates or the Standard Deviation you specify. You have control over the extremes to which the analysis performs. The J&L Financial Planner also gives you the option of choosing uniformly distributed random rates or Gaussian (normal) distributed random rates, as well as the option to use account rate ranges or group rate ranges. There is also a distribution factor setting that permits you to adjust the Gaussian Distribution.

SUMMARY

In summary, the Monte Carlo Analysis is able to estimate the probability of achieving the success of your financial plan by accounting for the yearly variability in the two main factors contributing to it's outcome, the return rate on your investments and the inflation rate. You can execute up to a thousand trials of your financial plan. Each trial is a fully independent execution of your financial plan, where each year the return rate on your investments and the inflation rate can take on a range of possible random values.

The large number of trials allows the analysis to compute the statistical probability your financial plan will be successful. For example, if after 1000 trials, 750 of those trials achieved your financial goals, your financial plan success rate is 75.0%.

If your financial plan rate is below your expectations the J&L Financial Planner allows you to make easy scenario changes to play "what-if" with your financial future.

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