If we could be sure that our investments would earn the same return year after year, and that interest and inflation rates would remain stable into the future, financial planning would be easy. It would simply be a matter of accurately estimating our contributions to those investments over time, and our anticipated future cash needs to achieve our goals. Unfortunately, for any given year in the future, we cannot accurately predict the return rate on investments, inflation rate, or interest rate. Yet, most financial plans assume a constant average rate of return, inflation rate and interest rate going forward. That's a very risky assumption, since these rates will certainly vary from year to year. Consider the following simple example:

You have a $100 investment portfolio and your assumption is that you will earn an average of 10% per year on that portfolio. Earning 10% each year, your portfolio value will grow to $121 two years from now. Given the market in recent years, a reasonable assumption, right? Not so fast! What if in Year 1 your portfolio earns -5% and in Year 2 it earns 25% (not unlikely given recent market volatility). In this case, your average return (arithmetic return) is still 10% over the two years, but your portfolio value will grow to only $118.75 two years from now. Given this simple yet graphic example, it's clear to see that by assuming an average rate of return on your investments over the full length of your financial plan, you could be creating unreasonably high expectations of achieving your goals.

Because we need to somehow account for future rates of return, inflation rates, and interest rates, but cannot settle for estimated averages, Monte Carlo simulation has emerged as a valuable and essential tool for effective financial planning. 

Monte Carlo simulation is a complex mathematical technique that estimates the probability of meeting specific goals in the future. In the context of financial planning, Monte Carlo simulation helps you to understand the likelihood of successfully achieving your goals, given the investments you have set up specifically for those goals. 

Monte Carlo simulation is able to estimate the likelihood of achieving your goals by accounting for variability in the factors that contribute to our financial plan's ultimate success (such as the return rate on your investments, the inflation rate, and the interest rate in any given year), and by running hundreds or even thousands of "trials" on your financial plan. Each trial is an independent projection of your financial plan, where each of the contributing factors noted above can take on a range of possible values in any given year.

When the simulation is complete, in some trials your financial plan has succeeded in achieving your goals, and in others it has not. The large number of trials allows you to know the statistical probability that your financial plan will enable you to achieve your goals. For example, if the simulation runs 1000 trials, and in 650 of those trials you achieve your goals with your investments, then the probability of successfully achieving your goals is 65%.

At that point, it's up to you to decide if you are comfortable with a 65% likelihood of achieving your goals. If not, then you need to consider how you might adjust your goals and/or investments to improve your plan's likelihood of success.

With Monte Carlo simulators, determining your plan's likelihood of success is the easy part - Typically, all you need to do is push a button and the simulator does the rest. The hard part is figuring out how to improve your plan's forecasted likelihood of success if you're not pleased with the simulation's results. Helping you with the hard part is what sets FinPlan apart.  

In FinPlan, if you're not happy with the forecast results, you can adjust a variety of inputs to try to improve the likelihood of reaching your goals: You can adjust your risk level (which will impact your overall recommended strategic asset allocation); you can adjust inputs related to the Portfolio Investment(s) dedicated to your Plan (such as the time-span of your investment, your expected periodic contribution to it, and any additional one-time investment you plan to make in the portfolio); finally, you can adjust inputs related to the specific goals for which the Plan has been created (such as the time-span of the goal, and the expected periodic and/or one-time withdrawal amounts necessary to achieve the goal). Once you've made the desired adjustments, click "Forecast" and see the impact of those adjustments on the likelihood of reaching your goals. 

Always remember, with Monte Carlo simulation, the forecast results are only reliable as your inputs to the model.

• Financial Planning - The Process
• Investment Process