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Financial Planners Rethink Monte Carlo Simulation Tools

By Money Management Executive
May 5, 2009
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Most mutual fund companies and financial planners rely on Monte Carlo simulation tools to help investors plan for their futures. They run thousands of investment scenarios to predict the success rate of probable portfolio returns given various contribution rates, investment mix and risk tolerances.

But virtually none were ever designed to take a year like 2008 or the current extremes in the market into account—which has prompted many statisticians to go back to the drawing board, The Wall Street Journal reports.

In the bell-shaped curve that Monte Carlo simulations use, “the probability of getting one of these extreme outcomes [like we saw last year] is basically zero,” explained Paul Kaplan, vice president of quantitative research at Morningstar, who notes that the Standard & Poor’s 500 Index has declined 13% or more in one month at least 10 times since 1926.

Thus, Monte Carlo simulators should be updated to include a larger number of scenarios that assume greater volatility, say critics, including the Retirement Income Industry Association.

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