Joe Taylor, who practices in Myrtle Beach, S.C., says:
"I believe Monte Carlo analysis is a helpful tool in financial planning, but too much credence is given to its output. Advisors must always remember the future is truly unknowable. I believe financial planning is a bit like navigating the open seas with a compass and a sextant; you have to take measurements and adjust your course often because the wind and tides will inevitably cause you to stray. Too many times, Monte Carlo analysis is thought of as navigating with a GPS system-you put in point 'A' and point 'B,' then just keep moving."
Bedda D'Angelo offers an important reminder that producing a plan is not enough: "The key here is monitoring. Many planners don't monitor once they have set the plan up. If you believe your first and only analysis is true, then you did not complete Step 6 of the financial planning process. ['Monitor the plan.'] In that case, clients may have been let down, but it was not by our tools. It was by our failure to monitor and misapplication of our tools."
Lessons Learned And Implications For The Future
The consensus among advisors, software developers and other experts is that there is nothing fundamentally wrong with Monte Carlo models. "They are not perfect," says Dr. Linda Strachan of , "but they are far better than the straight-line and deterministic models that have been used in the past." Strachan believes that Monte Carlo simulations, used in conjunction with other planning tools and techniques, offer the best planning outcomes.
Most experts and advisors seem to believe that the fault lies with the way the results of Monte Carlo simulations are being presented. Strachan says you must make a clear distinction between the model and the plan. If you run a model and it succeeds 100% of the time, that does not necessarily mean the plan is guaranteed to succeed in the future. Advisors must be sure that clients understand the distinction.
As for the criticisms of the assumptions and inputs, there is a corollary to the discussion that critics usually fail to mention. If you argue that most current Monte Carlo models under-represent the probability of extremely bad outcomes, it follows that we need to understand the implications if we adjust the models so that bad outcomes are drawn more often.
It should be pretty obvious that if we have more failed iterations, the odds of success for the typical plan will decline. Advisors will then be faced with the task of delivering the bad news to clients and offering solutions. Those solutions will include saving more, spending less, working longer or some combination of the three. Another conclusion one might reach is that the current portfolio is more "risky" than previously thought. If that is the case, perhaps the client will want to change the investment mix to one with less volatility. If he does, odds are the portfolio will have a lower expected return. Again, he will need to save more, spend less, etc.
After a historic market decline, some advisors may find it difficult sending this message now, particularly if they voiced a high degree of confidence in the model they used two years ago.
Monte Carlo simulations used in a vacuum are not a total financial planning solution. They can add value, of course, when advisors use them to educate clients about the volatility of returns and the probability of disasters. But they need to be used alongside other tools to assess various situations, including worst-case scenarios. Furthermore, financial modeling is still evolving. Some models are better than others, but there is no consensus about what represents the best model, so advisors must make their own value judgments.
Even when advisors use a good model with good inputs, they must take great care when helping their clients interpret the output. It is imperative clients understand that no model can accurately predict the unknowable future. Finally, we must never lose sight of the fact that financial planning is an ongoing process. Running a model and making a set of recommendations is not the end of the process. Periodic reviews and revisions are the only way to keep clients on course.