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Monte Carlo Simulation and Personal Finance

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Title: Monte Carlo Simulation and Personal Finance


1
Monte Carlo Simulation and Personal Finance
  • Jacob Foley

2
Background on myself
  • I work at Stephens Financial Partners as a
    Financial Advisor
  • Monte Carlo simulations are the most popular
    simulations used by advisors
  • These simulations failed after the 2008 market
    collapse

3
Where did it come from?
  • John von Neumann and Stanislaw Ulam
  • Los Alamos Scientific Laboratory
  • Studying radiation shielding

4
Why call it Monte Carlo?
  • Neuman and Ulams work had to be kept a secret
    because it was part of the Manhattan Project
  • Von Neuman chose the name "Monte Carlo".

5
What is it?
  • Class of computational algorithms
  • Used to solve large systems
  • Used when it is unfeasible or impossible to
    compute an exact result

6
Basic Principle of the Monte Carlo Method.
  • The Task Calculate a number I (one number only.
    Not an entire functional dependence)
  • Example Calculate pi
  • Numerically look for an appropriate convergent
    series and evaluate this approximately
  • Monte Carlo look for a stochastic model
    probability space with random variable

7
What makes a method a Monte Carlo Method?
  • Define a domain of possible inputs.
  • Generate inputs randomly from the domain using a
    certain specified probability distribution.
  • Perform a deterministic computation using the
    inputs.
  • Aggregate the results of the individual
    computations into the final result

8
Random Numbers
  • Uniform Distribution
  • The random variable X is uniformly distributed on
    the interval a, b

9
How many of you have played battleship?
10
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11
Dull Monte Carlo
  • hit or miss
  • Take a sample point
  • The point has two outcomes
  • True (hit)
  • False (miss)
  • Total number of hits and divide it by the total
    trials

12
Hit or Miss
I unknown area
f(x)
I ? f(x) dx
X
13
Crude Monte Carlo
  • Write the integral such that I becomes the mean
    value of a random variable.
  • Purposes we generate B numbers
  • Uniformly distributed from (0,1)
  • Then take their average

14
Take Numerical Analysis
  • Professor Robert Lewis
  • Math 413 and 414

15
Applications in the Real World
  • Physical sciences
  • Design and visuals
  • Telecommunications
  • Games
  • Finance and business

16
Monte Carlo in Finance
  • First Introduced in 1964
  • Risk Analysis in Capital Investment
  • David B Hertz
  • Harvard Business Review Article

17
So how does Monte Carlo apply to Finance?
  • Used to value and analyze
  • Instruments
  • Options
  • Portfolios
  • Investments

18
How does it predict values?
  • For each Simulation
  • The behavior of the factors impacting the
    component instrument is simulated over time
  • The values of the instrument are calculated
  • The value is then observed
  • The various values are then combined in a
    histogram (i.e. the probability distribution)
  • The statistical characteristics are then observed

19
How is it used in financial planning?
  • Simulates the overall market
  • Predicts the probability of reaching a target
    number
  • Changes are made to reach the target number

20
An Example
  • http//www.flexibleretirementplanner.com/

21
What works with Monte Carlo?
  • Forecasting Earnings
  • Modeling portfolio losses
  • Provides flexibility

22
What is wrong with Monte Carlo?
  • Assumes normal return distributions
  • We know from history that extreme returns occur
    more frequently than expected
  • Cant predict every outcome
  • Most clients see the simulation run through
    thousands of iterations and believe that they
    have seen all possible outcomes

23
What is wrong with Monte Carlo?
  • Does not measure bear markets well
  • Does not include the human factor

24
What is wrong with Monte Carlo?
  • Does not recognize that portfolio performance
    depends at least as much on the sequence of the
    rate of return that it does on the average of
    those returns

25
What can we do better?
  • Lets look at an example
  • Assumptions
  • 20 year period
  • Individual that has just retired in 1988
  • Has 1,000,000 invested in DJIA
  • Withdraws 50,000 each year that increases by 3
    to compensate for inflation

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30
Have multiple buckets of money
  • Dont just have your money in the stock market
  • Have money growing outside of the stock market

31
Homework
  • Estimate Pi using Monte Carlo

32
Thank You!
  • Any Questions?
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