chapter five

5 Monte Carlo Simulations

 

This chapter covers

  • Why simulations are an important tool for financial planning
  • Simulating returns in Python
  • Understanding the difference between arithmetic and geometric averages and simple vs. continuously compounded returns
  • Estimating the probability of running out of money in retirement
  • Implementing bootstrapping as an alternative to simulating returns
  • Incorporating additional risks in financial planning such as inflation risk and longevity risk

Monte Carlo simulations have numerous applications in wealth management and financial planning. In this chapter, we will focus on one particular problem that is particularly well-suited for Monte Carlo analysis: whether you will run out of money in retirement.

In Monte Carlo simulations, random scenarios are generated and analyzed. Most people focus on the randomness of stock and bond returns, but Monte Carlo simulations can incorporate anything random, like inflation, health care expenses, life expectancy, or even future tax rates.

5.1 Simulating Returns in Python

5.2 Arithmetic vs. Geometric Average Returns

5.3 Simple vs. Continuously Compounded Returns

5.4 Geometric Brownian Motion

5.5 Estimating the Probability of Success

5.6 Dynamic Strategies

5.7 Inflation Risk

5.8 Fat Tails

5.9 Historical Simulation and Booststrapping

5.10 Longevity Risk

5.11 Flexibility of Monte Carlo Simulations

5.12 Summary

5.13 Appendix