It has been said that if you want to start an argument on the Internet, all you need to do is state an opinion. From what I can tell, sharing a fact can do it too.

Many times, comments on articles or social media contain something of substance but often that is not the case. Some rants are funny or entertaining in a good way. Some are just plain mean and make you wonder how things got so nasty for the commenter that they became so unpleasant.

One of the few refuges from the ugliness has been the message boards of FPA and NAPFA. Sure, now and then someone gets, shall we say “passionate” about a topic, but most conduct themselves professionally. I have learned a thing or two just by reading through the digests, and they have inspired a few of these columns over the years.

Recently, a few FPA members had an interesting discussion about Monte Carlo simulations (MCS). Most commentary was negative and generally followed prior criticisms about the technique. A few suggested that MCS was misleading, even dangerous. With MCS so prevalent in financial and retirement planning software, I thought it might be worthwhile to bring some of the issues out.

The two criticisms I see most of the typical MCS function in planning software are that market returns have not conformed to a normal distribution curve and that with returns forecasted to be lower than historical averages, using historical data overstates a client’s chances of success.

I believe these two criticisms are valid, but I don’t agree with the assertion that MCS is, therefore, something planners should eschew for being misleading or dangerous. It can be a tool of great value. Like any tool, how you use it makes a difference. 

Let’s look at these criticisms.

There should not be any debate about whether returns conform to a normal distribution curve. The data speaks for itself. A log-normal distribution is a better fit for returns. Some critics go a step further and point out that even if you use a log-normal distribution in MCS, actual returns demonstrate fat tails. Extreme events, good and bad, have occurred more frequently than the curve would predict.

I have even seen several disparaging things said about MCS because the simulations “miss” so-called black swans. A favorite seems to be that based on historical data for daily behavior of the Dow, MCS software should predict a one-day decline of 22 percent once every gazillion years. Such an event is basically impossible, statistically speaking. Yet, it happened on Black Monday in 1987, so MCS is a farce.

I think this criticism is off the mark. I don’t dispute the statistics are not wrong, but the conclusion that MCS is, therefore, useless makes no sense to me. That is like saying you shouldn’t keep a screwdriver in your toolbox because screwdrivers won’t hammer nails very well. Are there really people that use MCS to predict daily returns or otherwise time the markets? I hope not. That is an improper use of the tool.

If we extend the time frame out to look at monthly or annual returns, the picture is clearer and the distribution looks log normal even if the tails are still fat. 

Are programs that use a log-normal distribution superior to those that use a normal distribution?  Possibly. Does it make a big difference? In many cases no. It doesn’t. Moreover, the difference shouldn’t matter if your expectations for what MCS can and cannot do are reasonable. More on that in a minute.

The second criticism is that with many believing future returns will be lower than historical averages, using historical data overstates a client’s chances of success. 

To this, I say, “duh.” If you think returns will be lower in the future than they have been in the past, of course projecting those lower returns will suggest weaker results. Do we really need software to make that case?

Don’t get me wrong. Arguments that returns are likely to be lower going forward than what the historical record would suggest, at least for a while, do not strike me as outlandish by any means.

There are few certainties with respect to markets, but with bond yields so low, there is a mathematical certainty that many of the good quality bonds on the parts of the yield curve we would consider will lag the returns of similar bonds in the past. How long this will persist is unknown.

It is also true that by many valuation measures, stocks are not cheap. How “not cheap” they are is subject to debate, of course, but regardless of what you think about valuation, it would be a stretch to assume current valuations are permanent.  

Nonetheless, are the critics correct in saying that if you use historical parameters with MCS, you are misleading clients? That depends on how you use MCS.

If you are using it as a crystal ball and telling clients definitively “you are going to be fine,” you might be encouraging an exaggerated sense of security. But using weaker than historic assumptions and definitively stating that clients are up a creek could cause an unneeded level of fear too. It can also cause them to work longer or spend less in retirement unnecessarily.

If you use return assumptions that are too gloomy for too long, you will be simulating an environment that has never existed. There may be value in that.

“Definitively” is where MCS can get misleading. That’s not the fault of MCS. That’s a user error.

We need to remind clients (and ourselves) that with respect to markets, just because something has never happened doesn’t mean it can’t happen and just because something has always happened doesn’t mean it always will again. If made a reasonable part of the conversation, these truths can help create a focus on adaptability and resilience.

MCS is so pervasive because it is better than old school deterministic projections at presenting possible outcomes not because it is supposed to predict actual outcomes.

I live on the Florida’s Space Coast. Area code 321, like a countdown. Some clients are actual rocket scientists. Precise use of sophisticated mathematics is critical. They perform a lot of simulations on projects with a lot at stake. I’ve been told by more than a few “You can’t simulate everything. There are just too many variables.”

That’s true with financial planning. There are too many variables, and we should not expect MCS to simulate everything.

Last month, I opened my column with this, “Good financial planning isn’t about forecasts or projections. It’s about managing one’s finances amid uncertainty.”

To the extent software helps clients’ decision making, I am interested in it. MCS can be used to help clients see how much uncertainty there is with respect to a successful retirement. From that, part of my job is to then help clients understand what is controllable and what isn’t. There is no “set it and forget it,” and MCS can help illustrate that.

Often, simulation results are presented as “you have 80 percent chance of not running out of money.” A better way to state it is “In 20 percent of the trials, there was a need to do something different than what we illustrated.” 

Some of the gold in the planning process is the conversation about when changes are indicated and what “do something different” should be. That’s preparing the client for reality. Preparation is a great defense against pressure and the emotional reactions that come with it.  

All software, regardless of the mathematical techniques embedded within, has limitations. If you are going to use software, with or without MCS, obviously you should know what assumptions are being used and the limitations that go with them.

I think you will be serving your client well if MCS is used to prepare clients for uncertainty rather than presented as a tool to eliminate uncertainty. That’s just not possible.

It is possible to help clients deal with uncertainty by being adaptive and building resilience. No software can do that, but there are many financial planners that do that every day.  

Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected].