Modeling Your Personal Finances: Part 1
Updated: Apr 7, 2022
In engineering and physics (my first two careers), the use of computers to model the behavior of complicated systems started during World War II and is now crucial throughout these disciplines. For example, nearly all aerospace, electrical, and mechanical engineers spend most of their time working with computer models running on simulators, instead of actually physically interacting with their designs.
A similar transformation to the use of models has occurred in the field of Personal Financial Planning. 20 years ago, wealthy clients who worked with a financial planner likely received a large, complicated Excel spreadsheet showing every calendar year for the rest of their lives and investment account values projected into the future, often with the key information and assumptions lost in the sea of numbers. Fortunately, in just the past 5 years, user-friendly, graphics-based financial modelling software has been developed by multiple companies. This software makes individual financial plans more easily constructed, more easily understood, and more widely available.
Key Assumptions can now all be included in your Personal Financial Plan/Model:
Your current spending
Your future spending
Your future income
The age at which you and your spouse retire
Large purchases (like children’s college, weddings, or a new car periodically),
Contributions and distributions to Retirement plans (e.g. 401(k), pension)
Investment rate of return
And pretty much anything else that might be significant in your financial plan!
A critical feature of this new software is the capability to vary these inputs, and then quickly see the effects on the overall plan, graphically, and over time. This used to be difficult using a large Excel spreadsheet!
Monte Carlo Simulation Modeling/Analysis:
Associating “Monte Carlo” with your retirement savings probably sounds like a risky thing to do, but Monte Carlo simulation a well-accepted and powerful method for dealing with complex situations (like your financial plan). Here’s a narrow example of what happens in a Monte Carlo simulation: the S&P 500 pool of U.S. Large Company stocks has had yearly returns of +8.5% on average over the past 100 years, but in any one year the return can vary wildly. For example, the largest recent negative year was 2008 at -37%, and the largest recent positive was 1995 at +38%. So how does a financial planner “model” this variability? They “roll” the statistical “dice” (that’s where the “Monte Carlo” name comes from) for the S&P 500 portion of your investments for each year to create a possible, simulated future. Since this is on a computer, it is easy to do 1,000 complete simulations by doing this 1,000 times for every investment type for every year!
The output of this Monte Carlo Simulation is a chart like the one shown here for a fictional 63 year-old (her age is along the horizontal axis) who is nearing retirement and who has just under $1million in assets (vertical axis). The dark line (in the middle of the shaded area) is the median simulation, meaning there were 500 simulations with results below that line, and about 500 simulations with results above the line. This particular plan shows a 75% confidence level that her assets will last until she is 100 years old, and a 5% chance that she will have almost $4Million when she gets to 100 years old.
A qualified financial planner can not only create the model that represents your unique situation, but can also help you understand it and utilize it to simulate the myriad of choices that we all have to control our financial futures. More on that in the next article!