Planning for your retirement would be easy if you could depend on earning the same amount year after year. You would know exactly how much you could afford to withdraw and would never have to deal with any uncertainties.
Monte Carlo simulation gives you a realistic assessment of how the future may unfold by looking at a wide variety of potential market scenarios. Instead of basing calculations on just one average rate of return, we generate 1,000 simulations of what hypothetically could happen to your assets during your retirement. Each simulation includes up and down markets of varying lengths, intensities and combinations.
By keeping track of the number of simulations in which your portfolio lasts for the duration of your retirement, we’re able to estimate the probability that your plan will be successful. For example, if your portfolio survives in 850 out of 1000 simulations, we can estimate that the probability of success is 85%.
Of course, it’s important to remember that Monte Carlo simulation assumes the future will be at least somewhat like the past - after all, we’re using historical data in each simulation. In actuality, the future may contain scenarios that are better or worse than anything considered by this tool. Monte Carlo simulation is one approach for modeling the range of possible future investment outcomes. Because other methodologies differ in certain assumptions, they may yield different results.