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Monte Carlo Program Considers Probability
The holy grail of Internet personal finance sites has been to create a retirement-planning calculator that's almost as good as a face-to-face consultation with a financial planner.
Now some sites offer something most financial planners don't: a calculation that estimates not just how much you need to save, but the probability that you will meet your retirement goal.
This powerful tool, known as a Monte Carlo simulation, is little understood in financial-planning circles, but it can have a dramatic impact on how you construct your portfolio.
So dramatic, in fact, that several leading financial planners--including planning guru H. Lynn Hopewell of Virginia--have urged their colleagues to incorporate Monte Carlo simulations in their practices. Hopewell and others say few have so far heeded the call.
Most planners and Internet calculators use static assumptions: an average 10% return, for example, with an average 4% inflation rate.
But as most investors know, the stock and bond markets don't offer steady returns, and wild fluctuations can wreak havoc with retirement plans.
Financial Engines (http://www.financialengines.com), the creation of Nobel Prize-winning economist Bill Sharpe and former Securities and Exchange Commissioner Joseph Grundfest, uses Monte Carlo calculations to simulate thousands of possible scenarios based on different combinations of investment returns and inflation rates. Instead of plodding along with one set of assumptions, the site's engine speculates what would happen to your portfolio if, say, a stock market crash of Great Depression proportions were to be followed by the inflation rates of the 1970s--among many, many other possible combinations. The engine then puts all those scenarios together to forecast your probability of success.
The results of Monte Carlo simulations can be eye-opening. Santa Monica financial planner Brent Kessel, who uses the simulations in his practice, said he did a typical static computation for one investor that showed he would die with $12 million, given an average 8% annual return and 4% inflation. When Kessel used a Monte Carlo simulation, however, it turned out that the client faced a 30% chance of running out of money before he died.
Knowing the probability of failure allows clients to modify goals and investments to boost their odds, Kessel said.
Financial Engines performs its Monte Carlo simulations based on information you input about your age, marital status, goals and investments. Unlike other sites' calculators, you do not input your expected returns; Financial Engines estimates those based on the historical and expected returns of the investments you have.
The possibilities are then plotted on a graph in a whirl of gray lines that the Web site sponsors liken to a tornado. At the end, your odds of success are estimated somewhere between 5% and 95%.
The free part of the site ends there.
For a fee the site allows you to adjust your assumptions to see how that affects your chances. You can opt to take more or less risk in your portfolio; delay or advance your retirement age; change the amount you want to save each year or adjust the amount of money you expect to live on.
With each change, Financial Engines' Investment Advisor tells you how to adjust your portfolio. The site uses Sharpe's groundbreaking work on modern portfolio theory--the work that won him the Nobel Prize--to offer specific advice about the mutual funds, stocks, bonds and cash in your 401(k). The site also allows you to input your other investments, such as those held in individual retirement accounts; these holdings are used in all of its computation and offers advice about investments held in IRAs.