Tuesday, November 4, 2008

What is a Monte Carlo Simulation?

If you've been interested in investing for a while now, you may have come across Monte Carlo simulations before. For those of you who may not have heard of it, let me explain. When calculating out the future value of your investments it is common to apply an expected interest rate over a number of years using the compounded interest equation. This works especially well if the exact interest and periodic payments are known in advance. For example, in a fixed-rate mortgage. However, when looking at your investment portfolio as a whole, there are many variables and most of them will change over time.

The purpose of the Monte Carlo simulation is to inject random variability into your calculations. You typically specify which variables will change and an expected range of variability. It is not hard to see that it would be difficult to construct a truly accurate model. This is why there are companies which specialize in creating software, backed by statistical data, to provide more accurate simulations.

Below are some links to information if you'd like to learn more.

Info: Investopedia, Univ. of Nebraska, Bogleheads Discussion
Free Software: Excel Add-in, Money Chimp, Flexible Retirement Planner

*If you're interested in commercial software for more accurate modeling, I recommend reading through the Bogleheads discussion above.