Monte Carlo Simulation: are your client's boots in the water?

• Author: Nightingale, Jerry
• Position: 2003 Technology & Business Resource Guide

Monte Carlo simulation is the latest statistical technique that financial planners are using to show clients the impact of an uncertain future on reaching their financial goals. Used correctly, the technique can give clients the probability of reaching their financial goals. For example, the simulation result may indicate that 95 percent of the time, the client's portfolio will be above a specific amount for retirement. However, the technique does have some shortcomings.

Before planners initiate running a Monte Carlo simulation, they should ask, "Are the client's boots in the water?"

IS SUCCESS OR FAILURE MORE IMPORTANT?

Perhaps an analogy will help. Suppose an electrician and a mathematician were reviewing a new product and analyzing the number of shocks that occurred when the product's electric cord was plugged into a socket. The wiring was properly installed, but the electrician would occasionally be shocked when he touched the cord.

The mathematician recorded the number of times the electrician touched the cord and determined that the probability of being shocked was less than 5 percent. Hence, the probability of success--not being shocked--was 95 percent!

How many times can you beat 95 percent?

Having never been shocked, the mathematician felt that the probability of shock was low enough to encourage use of the product.

The electrician, however, had been shocked a number of times and was interested in finding out more.

One rainy day, he realized he was getting shocked not 5 percent of the time, but every time he touched the cord. Looking down, he noticed his boots were standing in a thin film of water. He pulled over a stepladder, removed his boots and dried his feet. Cautiously touching the cord, he was not shocked.

The electrician noticed water accumulating on the floor from a leak in the roof. He stopped the leak, eliminated the shocks and supported the release of the new product with one caveat--don't stand in water when you plug it in.

The electrician discovered that the mathematician included too much of the universe of possible outcomes in his answer. When the count was confined only to the relevant data for failure, the electrician discovered that shocks occurred 100 percent of the time when standing in water.

Advisers and investors, like the electrician, should be less concerned about the probability of success and more concerned about the consequence of failure. While clients may be dazzled by a 95 percent probability of...