Financial planning the Monte Carlo way
By Laura Bruce • Bankrate.com

You wouldn't ordinarily confuse your financial planner with a Las Vegas odds maker, but if he or she starts talking about probabilities and outcomes and running your portfolio through some Monte Carlo simulations, you might wonder.

A Monte Carlo simulation is a mathematical tool that offers a way to evaluate a retirement portfolio to see if it will last a lifetime. With the help of computer software, a planner can simulate hundreds or thousands of market-condition scenarios and learn the probability that your portfolio would last your expected lifetime.

If your portfolio is run through 10,000 simulations, projecting 10,000 separate retirement scenarios, and it works 8,000 times, it means there's an 80 percent probability that the portfolio won't run out of money. If 80 percent seems too risky and you'd like to increase the odds to 85 percent or 90 percent, you could tweak the portfolio by adding more money to your investments or taking out less.

Simple calulations misleading
A more traditional way to analyze a portfolio might be to look at the individual investments in the portfolio and give each one an expected rate of return. For example, stocks should average 10 percent a year. Over the course of 20 or 30 years you could expect the portfolio to appreciate by a certain amount.

"We think projecting a future based on a flat rate is misleading in a worse way than Monte Carlo simulations can be misleading," says Dan Moisand, certified financial planner with Spraker, Fitzgerald, Tamayo & Moisand in Melbourne, Fla.

"It ignores the variability of assumptions that are made. You can pick any number -- if you average X percent each year, this is what it will look like. But in reality it doesn't work out that way. Monte Carlo helps bring in that variability and paints a more dynamic and realistic picture.

"The average rate of return has a 50/50 chance of happening. No one wants their retirement to come down to a flip of a coin. They want something bigger than a 50 percent chance of success."

Monte Carlo not infallible
The math formula behind Monte Carlo has been around a long time. Supposedly it was developed during the Manhattan Project, the U.S. military effort to develop an atomic weapon during World War II. While Monte Carlo simulations have been available to financial planners for many years, the forecasting method only recently caught on with the advent of high-powered personal computers that could speedily handle the calculations.

"There's nothing magical about it or any other type of analysis," says Dan Candura, certified financial planner with ING Financial Horizons in Boston.

"The future is unknowable, and short of the Oracle of Delphi, it's been a long time since anyone predicted the future.

"These tools give you possible scenarios of the future. They help us make better decisions but not perfect decisions.... There's a lot of usefulness, but it's not new technology even though there's a lot of buzz about it."

Candura uses Monte Carlo in conjunction with other forecasting techniques, as do most financial planners who run Monte Carlo simulations.

The retirement income calculator that investment management company T. Rowe Price makes available on its Web site uses Monte Carlo simulations.

Christine Fahlund, vice president of T. Rowe Price Investment Services, says it's important to be very conservative in projections, especially in terms of how much money you'll withdraw from the account during the early years of retirement.

"We looked at bear markets in the first years of retirement. We knew our investors would be fine if they didn't lose any money early in retirement -- actually growing the pool of money, spending some but it keeps growing. Eventually, you might be able to take out more than you planned, but we focused on what if there's a bear market early on. What you're taking out and what the market is doing to your portfolio are two major factors."

Just as with almost any other financial projection, it's garbage in, garbage out. You need to be realistic in estimating your expenses during retirement. If you underestimate and need to withdraw more than you planned, the probability that your portfolio will last your lifetime goes out the window.