Retire Early? by Steven A. Silbiger

Author:Steven A. Silbiger [Steven A. Silbiger]
Language: eng
Format: epub
ISBN: 9780061753121
Publisher: HarperCollins
Published: 2005-11-15T00:00:00+00:00

MONTE CARLO STUDIES

Rather than basing plans on market averages, the Monte Carlo approach uses estimates based on probabilities. Using powerful computer programs, technology has taken the historical studies a step forward. In back testing, the historical results were kept in time sequence, but in Monte Carlo studies, each year’s returns are maintained separately in pools. It’s a little like a roulette wheel, where each year is a different spoke of the wheel, hence the reference to the historic gambling capital of Europe. The Monte Carlo simulator draws the pools of returns for many sequences randomly based on return and volatility. It does it thousands of times and creates a distribution or graph of the possible results. It is like living the lives of thousands of people all at once and trying to find out how real results, not average results, would occur.

Frank Armstrong of Investor Solutions, Inc., explained it best, “Suppose we expect a portfolio to be worth $100,000 at the end of a period for a particular withdrawal rate, rate of return, and time horizon. If one result yielded $1,000,000, and nine yielded $0 at some particular risk level, we have achieved our average return. But nine out of ten retirees are broke!”

Monte Carlo analysis shows that when the projected volatility increases by the addition of more volatile investments, there may be the same mathematical “average” return, but the median is less than the average. In other words, if you line up all the results side by side, the actual middle (median) results of real individual results are less. In the extreme volatile series of data in the example, $0, $0, $0, $0, $0, $0, $0, $0, $0, $1,000,000, the average is $100,000, but the median result is $0. If you were relying on the $100,000 average to be your result in retirement and you earn $0, you are not only going to be upset at your financial planner, but you are also going to be bankrupt.

If you have a sophisticated financial advisor, he or she may already have a Monte Carlo simulator to wow you with. A simplified version of a Monte Carlo simulator is available at Troweprice.com at the area labeled Retirement Income Calculator (www.troweprice.com). This is a key tool that’s available to you so you can get an idea about your own portfolio and withdrawal rate. By the way, Morningstar highly rates many of the T. Rowe Price mutual funds. Another sophisticated model available for free is called “The Retirement Probability Analyzer” provided by the Society of Actuaries Web site at www.soa.org. The model created by Toronto finance professor, Moshe Milevsky, uses partial differential equations to calculate the “probability of ruin” as he calls the demise of a retirement portfolio.

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