From hroberts@uic.edu Mon Feb 12 08:40:26 2001 Date: Sun, 11 Feb 2001 11:47:12 -0800 (PST) From: hroberts@uic.edu To: hroberts@uic.edu Subject: Forwarded article: MONTE CARLO MOCK-UPS FILL IN SOME OF THE BLANKS The following article was selected from the Internet Edition of the Chicago Tribune. To visit the site, point your browser to http://chicagotribune.com/. ----------- Chicago Tribune Article Forwarding---------------- Article forwarded by: Helen Roberts Return e-mail: hroberts@uic.edu Article URL: http://www.chicagotribune.com/business/printedition/article/0,2669,SAV-0102110011,FF.html ---Forwarded article---------------- MONTE CARLO MOCK-UPS FILL IN SOME OF THE BLANKS Kathy Kristof You can't predict the future. But financial planners have always given the impression that they can, promising that if you set aside a certain amount and invest just so, you'll end up with enough money for a comfortable retirement. Now an increasingly popular financial tool known as a Monte Carlo simulation is underscoring what insiders have known all along: Long-term financial planning is still a gamble. But with this new tool--named after the famed Mediterranean gambling resort--consumers can at least know the odds. Why should you care? Because it's important to realize that things may not work out the way that nifty retirement calculator you found on the Internet said they will. And that can help you prepare for--or at least not be surprised by--unexpected events. "Every financial planning decision involves a certain amount of guesswork," says Joel Goldhirsh, a planner with Goldhirsh & Goldhirsh in Irvine, Calif. "This process takes out some of the guesswork by helping us determine the probability of accomplishing our stated objectives." To understand how Monte Carlo departs from traditional planning and why it has become so popular, you have to understand how traditional planning works. In a nutshell, it's based on mathematically projecting whether today's investments will be worth enough to meet your financial needs in the future. However, the formula assumes that your needs remain relatively constant, as do your savings patterns and investment returns. Here's an example: Say you need to know what $10,000 invested in stocks will be worth 30 years from now. A planner will plug $10,000 into a formula that assumes you'll earn an average of 11 percent a year over 30 years--about what the S&P 500 has returned over the last 70 years. The answer: $267,080.97. The precision of that response may lead you to believe it's accurate. But the dirty little secret in financial planning is that it's not. Or, rather, it's not necessarily. Here's why: While the average return on stock investments may be 11 percent a year, the real return rarely hits the average. Instead, you're likely to be up 25 percent in one year, down 5 percent the next. Volatility can have a huge impact on the final result. Sam Savage likes to use a human example to illustrate: There's a drunk weaving back and forth across a busy four-lane highway. If you look at his average position, he's in the middle of the road and he's alive. But in reality, he's probably dead, because that average position is an inaccurate indicator of where he's been, says Savage, director of the industry affiliates program in Stanford University's department of management science and engineering. The idea of Monte Carlo simulations is to take a look at all the places your investments are likely to go and then project the chance that you will survive financially. You do that by having a computer model take thousands of snapshots of what your investments would be worth in the future, given thousands of different year-by-year returns. Thanks to powerful computers and sophisticated software, it takes just seconds to determine your chance of accomplishing a goal, whether it's making your $10,000 grow to $267,000 or having a retirement nest egg that will generate a set amount of income. Financial planners will do this on a computer in their office. You can watch it yourself by visiting one of several Web sites, such as Financial Engines (http://www.financialengines.com) that use Monte Carlo simulations in retirement planning. Instead of saying that your $10,000 will be worth $267,000 in 30 years, the computer may--depending on which Monte Carlo simulation it uses--calculate that you have a 50 percent chance of having $267,000, a 4 percent chance of having $45,000 and a 10 percent chance of having $350,000. Naturally, the practical implications of having $45,000 versus having $350,000 are enormous. So planners will use these analyses to urge their clients to save more, invest more aggressively or live on less in retirement to boost the projected success rate into the 80 percent or 90 percent range. Some planners are worried about something else: The dazzle of this formula might mask the fact that financial projections are only as good as the data you plug in. But Monte Carlo calculations don't account for unexpected children or for children who end up at Harvard. They don't address bad bosses, disabilities, lottery winnings, inheritances or hundreds of other possibilities. In reality, there are far more moving parts in a retirement plan than just investment returns. Planners also are projecting how much you're going to earn and contribute to the pot, how long you're going to continue working, how long you're going to live, and what kind of monthly income you're going to need 20 or 30 years from now, given what they expect to happen with inflation. "There is a problem with planners being seduced into thinking that they have solved the problem of uncertainty," says Tim Kochis, partner with the San Francisco planning firm of Kochis & Fitz. "In reality, they've only solved a few of the uncertainties."