Hi Guys,
I truly do not understand the reluctance of a few MFO participants to consider adding Monte Carlo methods to their financial toolbox. It is a powerful tool with unique capabilities and is specifically designed to address complex and uncertain issues. Offhand dismissal of the technique is not a sound strategy.
Monte Carlo formulations have a distinguished scientific history. Enrico Fermi used it to model atomic neutron diffusion in the 1930s. Stanley Ulam and Johnny von Neumann formalized the tool when developing nuclear fusion algorithms at Las Alamos, New Mexico in the early 1940s. The technology was given the Monte Carlo name because it was a secret World War II project.
It was slowly introduced into the financial and investment community as computers became cheaper and more accessible. Nobel Laureate Bill Sharpe made the tool available to the general public with his Financial Engines website in 1996.
Here is the Link to the website:
http://corp.financialengines.com/Take particular note of the financial institutions that use the Financial Engines toolkit. The extensive listing is literally the honor roll of the investment universe. That is a well recognized accolade for a tool that helps in the decision making process for modeling very uncertain events.
The three major mutual fund houses (Vanguard, Fidelity, t. Rowe Price) all offer a Monte Carlo simulator. Financial business entities all deploy various types of Monte Carlo programs to facilitate and to formalize their decision process. Private Monte Carlo codes are accessible to individual investors from numerous sources. The Monte Carlo simulator is ubiquitous throughout the financial industry for solid reasons. It yields guideposts for uncertain investment decisions.
I have mentioned my favorite “The Flexible Retirement Planner” in earlier postings. Here is the Link to that excellent resource:
http://www.flexibleretirementplanner.com/wp/I also like “Moneychimp” because of its simplicity. Here is the Link to that tool:
http://moneychimp.com/articles/volatility/montecarlo.htmIf you are not comfortable with pure Monte Carlo codes, you might like a different approach offered by Firecalc. That site uses actual historical returns with structured starting dates to generate a set of equity returns. Here is the Link to that website:
http://www.firecalc.com/I am constantly amazed at how quickly an investor can explore his retirement possibilities and pitfalls.
To illustrate, I’ll use The Flexible Retirement Planner to explore three retirement dimensions. As a baseline, I’ll postulate a portfolio with a 7.5 % average annual return with a 13 % standard deviation volatility. That’s representative of a 60/40 equity/bond portfolio mix. I’ll assume a 30 year portfolio survival requirement with an initial $40,000 annual drawdown need (these programs adjust for inflation; I selected a constant 3 % level).
First, I’ll postulate initial nest-eggs of $500,000, $750,000, and $1,000,000, all in taxable accounts. For these starting conditions, the Monte Carlo analyses projected survival likelihoods at a disastrous 2 %, an unacceptable 31 %, and a highly risky 68 % rate, respectively. That’s a significant and appalling insight. Retirement is not a good idea.
Second, how much of an improvement can I anticipate if I cutback my annual withdrawal rate to $35,000? Again, for the $500,000, $750,000, and $1,000,000, portfolios, the survival probabilities become 7 %, 50 %, and 81 %, respectively. I’m still not sanguine with these likelihoods. Still too, too risky.
These simulations suggest that I should delay retirement until I acquire a larger nest-egg. How much does a $1,250,000 portfolio enhance the odds? The survival prospects increase to an attractive 94 %. Patience will be rewarded.
Third, s few sensitivity scenarios are worth exploring. For example, what is the deterioration to the 94 % success likelihood if the portfolio only provides a 7.0 % annual return rate? The Monte Carlo code generated a respectable 91 % survival probability. That output suggests some robustness to the plan. What-If scenarios are easily examined on these Monte Carlo tools.
This entire analytical sequence took about 15 minutes to complete. The study is surely not exhaustive, but serves to illustrate the instructive power of these Monte Carlo programs.
Indiscriminately tossing the Monte Carlo codes away as not trustworthy or useful is shortsighted and misguided. These tools certainly can not predict future investment returns; nothing and nobody can. But they do provide guidance and awareness of the risks associated with numerous investment and retirement decisions. In these uncertain environments, Monte Carlo probes can be deployed to estimate the success/failure odds and to discover approaches that can enhance any troublesome odds.
Monte Carlo will do workhorse duty for you if you just give it a test ride.
Your comments are always welcomed.
Best Regards and Merry Christmas.
Comments
One poster (not me) said this "simulation nonsense" was good for entertainment and self deception. It's nice to see some free spirits posting here for a change instead of the usual ultra-conservative investors who so dominate this board. I believe that poster also trades the leveraged Pro Funds both long and short, something I am totally opposed to, but again, a fresh change of pace for this forum.
Look, I respect the fact you are into stats, numbers, the complexity of investing, and believe investment success is a function of a high intelligence (albeit in reality, or at least my world, there is nothing complex whatsoever about it and with no great intelligence required) I would wager your professional background was engineer, scientist, computer programmer, or the like. But not everyone here comes from such a background. Read the Tao Jones Averages by Bennett Goodspeed sometime when you get a chance, a guide to whole-brained investing. You will never change the rigidity of your mindset and that's fine. We are who we are. But go with the flow a bit more and realize not everyone here is on the same page as you when it comes to investing. I know they certainly aren't on the same page as me and that doesn't bother me one bit. I am not here to preach and evangelize seeking converts to my way of thinking. Just offering a different perspective from an old-timer who made his first trade almost 50 years ago (five shares of Chrysler)
As for monte carlo, again, say an hypothetical investor age 66 has a $2,000,000 nest egg with a withdrawal rate of $35,000 annually. Do you need monte carlo simulation or some advanced degree to realize he has more than enough of a nest egg where he doesn't have to obsess about outliving his nest egg, especially since that nest egg is continually compounding. Obviously someone in less beneficial circumstances age-wise/portfolio size/withdrawal rate size might have to fret about outliving his nest egg. But I would think they might be better off spending less time on the monte carlo "nonsense" and more time on compounding their nest egg. Just my two cents from a simple-minded trader/investor who marches to the beat of a different drummer.
Edit: Forgot to mention, as wordy, repetitive, and haughty as you posts sometimes may be, still enjoy reading what you have to say so keep them coming.
I happen to think monte carlo is an interesting tool, mostly because my brain is comfortable with numbers. I've been using statistical process control and lean manufacturing techniques my whole career to improve the manufacturing process. I like that percentages and probability can give insight and help guide me in choosing a path forward. Saying that, I'm not sure monte carlo really steers peoples actions. But that's neither here nor there.
Your back ground as trader/investor sets you apart from probably 99% of the people here (how's that for a meaningless statistic used in a discussion
I guess what I'm trying to say is, your comment, is easier said than done by most everyone on this board. It ain't gonna happen.
In closing, unlike that other guy, you are interesting to the point, un-wordy and un-haughty. If you put out a news letter laying out your timing and trades, I'd probably buy it. But I'll run monte carlo from time to time too - can't help myself. Keep up the posts...
As for a newsletter or timing service I had to laugh at that. I spent a lifetime going after the newsletter writers and Dream Merchants (trading vendors) in other venues and their promises of instant trading and investing wealth with their claims of 100% and 200% returns or more. With me it was put up or shut up as I was always challenging them to provide a multi-year (the longer the better) documented track record of actual success with *real* money trading/investing at a *real* money brokerage firm. None of their back tested, curve-fitted hypothetical results. I even offered to show my actual real money statements for three, five years, or longer if they would do the same to back up their claims. But alas, they always seemed to have a 1001 excuses why they could never validate themselves when real money was on the line.
Edit: I think I mentioned in an old post how this has been my most frustrating year ever. While I may have continued to consistently compound my trading capital (who hasn't this year) many of the individual stocks I was in and recommended (including under my old handle of hiyield007) ala LGND, SNTS, NPSP, RAD, and ACAD have more than doubled from my entry posts. Yet my aversion to even the slightest of volatility along the way prevented me from enjoying the full rides up. Stocks never were and never will be my thing as compared to the tight rising low volatility channels of equity funds (thank goodness for the 80s and 90s) and most especially bond funds (the past decade)
Well, it seems to me that since they certainly can not predict future returns, the guidance they can provide as to future risk only will extend through the range of vague to misleading, nothing more. Sticking to the 'vague' portion of that spectrum, that's nice and no doubt better than nothing, but I can give plenty of other ways to provide vague guidance towards risk:
1. Check the investment's standard deviation. The higher the deviation, the greater the risk.
2. Check the investment's correlation to something else you own. Negative correlation (if continued into the future, and that's the 'if' that makes this vague) will reduce the risk of adding it to your portfolio.
3. Higher valuations (by whatever ratio) of whatever investment increases the risks of losing money on that investment.
And so on and so forth. I'd guess that the most dangerous things about Monte Carlo simulations are the spurious probability numbers that they spit out. The unsuspecting investor is likely to treat these as possessing an exactitude which they simply do not possess.
For my tastes, historical drawdown ratios are a far more concrete way to get guidance as to the risks involved with investments. These are vague, too, since history at best rhymes (rather than repeats itself), but, as I say, the best way is probably more a matter of taste than anything else, which follows from the inherent vagueness of every method. The inherent uncertainty of the future cannot be escaped.
Hi Junkster,
Thank you for taking time to read and reply to my post. I appreciate both your interest and your thoughts on the matter. You surely present a welcomed different prospective.
Executing a successful investment program may conceptually be a simple task, but it is not an easily executed assignment. Plentiful evidence of the difficulty overwhelms us. Individual investors only recover one-third of the market rewards over time; professional money and mutual fund managers often fail to capture index-like returns. The interconnected linkages that govern macro and microeconomic happenings are far too numerous and too dynamic to model with any reliable fidelity.
I certainly agree with your observation that an individual with a 2 million dollar portfolio and a drawdown requirement of only 35 thousand dollars annually doesn’t need the sophistication of a Monte Carlo analysis. That’s an easy strawman case to make.
My posting was firmly directed at those folks who struggle to satisfy savings, investment, and retirement decisions under tipping point conditions. I suspect most folks fall into that stressful category. My wife and I sure did. Monte Carlo analysis served us well during such worrisome circumstances.
Yes, during my pre-retirement life I was an engineer. My wife was an experimental scientist. We consult and make team decisions. We were both intimately familiar with mathematical tools and modeling construction so the Monte Carlo approach was a comfortable tool to adopt to supplement our financial decision making. Not everyone will be in a similar position.
If Monte Carlo methods are outside your comfort zone, simply do not use them. Everyone has the freedom to choose their own investment philosophy, rules of engagement, and toolkit to implement their selected strategy. I welcome the diversity in strategies since these ultimately drive the marketplace to more efficient pricing. Active traders are a necessary ingredient in that mix. I thank them all for carrying a heavy load.
Investor success and high IQ doesn’t always highly correlate. Emotional stability and behavioral biases have a major impact on investment success. In the preface to Ben Graham’s “The Intelligent Investor” classic book, Warren Buffett stated that, “To invest successfully does not require a stratospheric IQ . . . . What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework”. Monte Carlo calculations will do nothing to control the emotional dimension.
Studies that examine the relationship between IQ and investing results yield a mixed conclusions bag. Here is an abstract from a study completed by Mark Grinblatt and company titled “IQ, Trading Behavior, and Performance”:
“We analyze whether IQ influences trading behavior, performance, and transaction costs. The analysis combines equity return, trade, and limit order book data with two decades of scores from an intelligence (IQ) test administered to nearly every Finnish male of draft age. Controlling for a variety of factors, we find that high-IQ investors are less subject to the disposition effect, more aggressive about tax-loss trading, and more likely to supply liquidity when stocks experience a one-month high. High-IQ investors also exhibit superior market timing, stock-picking skill, and trade execution.”
Other studies conflict with this IQ correlation finding.
I have always favored Tom Bulkowski’s technical analysis because he typically includes probability of success odds for the countless formations that he analyzes. These days, I use his graphic interpretations as a secondary, confirmatory-like reference. Here is the Link to his superior website:
http://thepatternsite.com/
I would never solely use technical analysis when making an investment decision. Likewise, I would never base a decision solely on Monte Carlo analyses. Each has its merits and pitfalls. Each tool in an investor’s toolkit must be judiciously used for specific purposes. As a general rule, the more tools accessible, like the MFO website, the higher likelihood of a successful investment decision.
By the way, Bulkowski’s book “Encyclopedia of Chart Patterns” contains an excellent Statistics Summary section of all his pattern formations with a listing of a probability failure rate and a likely estimated gain or loss. Most technical analysis books do not document these additional estimates.
Indeed, the MFO site likely attracts conservative investors. That’s obvious because it primarily services mutual fund users. Mutual funds, with its holdings diversification, were originally constructed as long-term investment vehicles offering a lower risk profile than individual stocks. From a time perspective, that has devolved somewhat. Today, relaxation of trading rules is the order of the day by profit seeking firms. Basically, I still do not play in that arena. I remain in the conservative investor camp, especially when using a trading infrequency measure.
All investors have the freedom to choose their own poison, their own modus operandi. I was just alerting MFOers to the potential benefits of Monte Carlo simulations, perhaps another form of poison, but from my perspective, a wealth protecting, somewhat magical elixir.
Once again, thank you for participating in this exchange.
Best Wishes.
Nice post. I particularly liked your closing statement: “The inherent uncertainty of the future cannot be escaped.” I completely agree; I hope my postings give proper recognition of that inescapable conclusion. Monte Carlo analyses shine under those cloudy circumstances.
Monte Carlo methods allow a rapid assessment of risks under numerous potential scenarios. By examining a plethora of possible happenings, the odds of likely outcomes can be estimated. Hundreds, even thousands, of randomly selected cases are calculated for each input run. The value of Monte Carlo simulation rests in its exploration of these uncertain outcomes.
Of course, the more realism, in terms of modeling influential parameters and real world data, that can be introduced into the simulation inputs, the more reliable will be the odds estimates. In World War II, convoy routes and screening strategies, and attack submarine groupings and tactics were evaluated using rudimentary Monte Carlo modeling tools.
Along with your cautionary comments, I would emphasize that the simulation outputs are merely approximate probabilities. They should be interpreted just like horse racing odds – no guarantees whatsoever. The resultant odds change with any modifications to the input parameters.
The power of the Monte Carlo codes is that they permit sensitivity, “what-if”, studies. Input values can be conveniently adjusted to search for exploitable trends that move the odds towards more likely and more attractive outcomes. These outcomes are forever tied to the inputs. I hope that I clearly made that point. Garbage in, garbage out always applies.
The inputs could reflect past performance data or any perturbations that the code user elects to test. His choices and any special input preferences will be reflected in the output probabilities. Only the user can judge the merits and shortcomings of his analysis.
I understand that neophyte users might be tempted to overly trust any output that has seemingly very precise number values. That’s a cardinal sin; it is only an artifact of the computer’s number crunching and display power. The overarching uncertainties of future returns remains a mystery. The Monte Carlo analyses merely identifies the level of that risk, and perhaps an asset allocation mix that minimizes that risk. By all means, buyer beware.
I’m sure you realize that portfolio standard deviation estimates are part of the investor Monte Carlo inputs. The portfolio standard deviation is calculated by holding weight factors and the correlation coefficient estimates for all the various portfolio positions. These too can be parametrically examined in the overall simulation process.
Thank you so very much for your informed and discerning contribution to this exchange.
Related to this topic there is a Free course at Iversity starting Jan 20th.
Monte Carlo Methods in Finance
Course will be delivered by Prof. Dr. Alberto Suárez.
I am registered at this course. As a side note I've recently completed "Computational Investing" course at Coursera which was delivered by Georgia Tech Prof.
I’m pleased by your message. Our exchanges have been in a hiatus for far too long.
I’m not surprised that you are adding Monte Carlo analyses methods to your toolkit. Like me, I suspect you strive for constant learning, especially in the marketplace.
Just yesterday. I purchased yet another lecture series from The Great Courses outfit. This new course is titled “Behavioral Economics: When Psychology and Economics Collide”. I hope this course will allow me to better identify tipping points in the market’s grand directional shifts. Hope springs eternal.
Congratulations on your recent and your future educational advancements. Monte Carlo is an exciting and useful tool. It should enhance your likelihood for investment success.
Also, thanks for the tips on available Monte Carlo educational material.
I surely wish the best for you and your family.
Merry Christmas.
https://www.edx.org/how-it-works
To meet increasing demand, which apparently can't be met with traditional route:
The situation creates More background here:
https://engineering.mit.edu/newsletter/2
and
http://future.mit.edu/preliminary-report
Hi Charles,
Thank you for the alert that introduced the free educational courses currently planned and available to the general public. The list is impressive and contains many subjects that interest me.
However, I doubt if I will sign-up for any of them. These are formal college level courses that are seriously presented. Sample problems, required reading, and homework assignments will be integrated into the presentation materials. That’s simply too serious for my interest level; it is a bridge too far for my limited goals. Overall. it is far too formal for my purposes and enjoyment.
In reality, the course work is not free since it will demand a considerable commitment of time. At this juncture in my life, time is my most prized commodity. That’s one reason why I invest in mutual funds and ETFs instead of separate stocks.
Indeed I did pay for The Great Courses DVD series on Behavioral Economics. That makes it the 34th time that I purchased one of their almost 500 courses. I don’t want to tout their product line on MFO, but I have enjoyed and learned from each lecture series. Viewing flexibility and reviews are yet other important ingrediens.
So has my wife and so has many family members. These series are so attractive that they are widely circulated within our family circle with considerable enthusiasm. It’s a win-win scenario at very modest costs, either financial or time-wise. I will likely continue to be a satisfied customer.
Again, thanks for the heads-up. Our universities frequently offer one-off lectures by prestigious professors as an introduction to a topic or as a preview to more formal course work. In my opinion, these are very good, but not as carefully crafted as The Great Courses format. Each one-half hour lecture is a joy.
Best Wishes and Merry Christmas.
Seems like never before has the opportunity for education been available to so many! And, once employers start recognizing these credentials, it will change everything.
Wishing you and yours all good things for the holidays.
Hi MJG, sorry for my sporadic posts these days. Between Free courses I am taking, the homework's, tests etc., usual work as engineer, home duties, kid's band winter concerts etc. I've been rather busy. So, I did not have much time left anything else. But, I am not complaining. I kind of like being able to step away from the noise of markets.
I've got 8 pages of unread posts thanks to Ted! But, I am able to skip most by just looking at the headlines. Over the years, I came to expect what pundits would write based on the headline
Having said that there is a Free Behavioral Economics course. It was offered back on October but I believe course material remains available online and you can register and simply audit the course (You are not required to take exams or complete exercises). Here it is:
https://www.edx.org/course/university-torontox/university-torontox-be101x-behavioural-1009
An admiring note for your efforts to patiently share your knowledge.
Concur wholeheartedly regarding the utility of Monte Carlo for the purposes you describe and with Great Courses for the curious but time strapped!
Best and Happy Holidays...