The purple graph on this page is a simulation showing the potential outcomes of 125 financial plans for the same person using randomly differing rather than static rates of return, inflation rates, mortality, and so forth. The rates used to project these futures are selected within limits by something called a Monte Carlo simulation program and then displayed in this graphic form.
If this graph were showing your financial plan, it would tell you that an estimated 90% of the time your plan is expected to work and, contrarily, 10% of the time it may fall short and require substantive adjustments or intervention to meet your needs for cash in the future.
A 90% chance may seem poor to some of you. In our example, some of the graphed futures result in a positive, growing net worth.
Others tail off into early asset depletion and financial failure. In reality, neither of the extremes shown on the chart would take place. No one would drive an unsuccessful spending plan that far into the ground without police intervention.
Conversely, plans that produced much wealth would result in increased spending. But also remember, none of these outcomes lead to becoming broke or rich quickly. Also notice that if a simulation predicted 100% success, it would tell you that you already have every penny you will need and that your retirement will work even in very adverse circumstances without your lifestyle changing one whit. We recommend Monte Carlo simulation to help you make decisions about retirement, job change, expense reduction, and how realistic your goals are. For example, can you really afford that boat? Can you retire early? Can you send your children to an Ivy League college, or will they have to go to a less expensive school? Can you make a big gift to your church now?
Our last article on this subject (Spring 2000) told you of our concern that the public may think that Monte Carlo simulation might be a substitute for close annual review and revision. If things go wrong financially, most of us will survive and prosper if we just adjust our expenses and cash flow needs in a timely manner. With early warning and decisive action, abrupt negative changes in lifestyle may be avoided. Continued comfort and security requires projection and planning. If you have developed the discipline of regular annual review, you know the truth of this statement. Making adjustments to changing conditions is part of the implementation of every good financial plan.
Next time you call to set up a review, let’s discuss whether a Monte Carlo simulation can help you adjust to changes in your finances. Our new simulation tool is part of new software which includes all provisions of the new tax law.
Curious? Call for a review.