What is a Monte Carlo Simulation

The future is inherently uncertain. When thinking about our future goals, we need to consider what the chances of meeting those goals are. To do that, we introduce the Asset Score.

👤 Who

All users that are utilising Strategy Builder for modelling.

ℹ️ Mapping the Future

iff thinks about the future as possibilities. Lots of different possible future worlds. To do this we use a technique called the Monte Carlo simulation. This technique allows us to account for the likelihood that our estimates of the future are only that – guesses. Some we have higher levels of confidence in, and some are extremely vague. This is especially true when it comes to estimating the likely returns for investments.

As an example, consider how the future may play out for Australian Equities. We can start by assuming that the average annual return over the next 10 years will be 7% per annum. Given the historic variability of Australian Equities, the chart below shows future paths that are consistent with that 7%pa return. From a worst-case outcome of -6.9%pa to a best-case outcome of 21.3%pa.

This range of outcomes reflects our confidence in the expected return of 7% - i.e. not very high. While we believe the most likely outcome is 7% return per annum, out of 100 future possible paths, only 25 produce annual returns between 5%pa and 9%pa.

That leaves 75% of the outcomes more than 2%pa away from our most likely result.

This approach can be extended to all investment opportunities (including residential property) as well as to the potential paths of inflation. This allows us to model future wealth (and income) across lots of different potential future outcomes, allowing for the fact our expectations of the future are less than perfect. Building portfolios that utilise diversification is an important way to reduce uncertainty about the future. Combining two assets that behave differently (like bonds and equities), reduces the range of potential future paths.