Why are the Monte Carlo results so low initially?

If you look at the help manual, page 61, you see that ALL Monte Carlo results are Less than the TIPS or projected. There is something I'm really missing. How is this possible and what does it mean? Is it really possible that all (95%) trajectories with stock end up worse than TIPS? That seems implausible.


dan royer's picture

My understanding of the MC analysis is that we get to look at random distributions, ranked from low to high. I don't know the asset allocation of that portfolio off hand, but if there is some percentage of stocks--even a small percentage I assume--then it seems reasonable to me that it's possible that in some given year that the portfolio does poorly, creating a significant hit to the living standard. If someone were to buy all TIPS (actually can't imagine anyone doing that outside of a mutual fund) then they may be better off in a given year than someone with 90% TIPS and 10% S&P as far as the distribution goes in that year. Imagine, for example, that you set up these allocation in 2008.

But how these distributions works exactly is over my head. There's a lot of math there. I look at MC but prefer to trust my instincts on the relative risk of nominal returns.

Coincidentally, I had exactly the same question on my mind when logging in. It's particularly puzzling to me because it occurs in my reports in the years until retirement. After that it goes up.

My pre-retirement years are primarily dependent on my earnings. The MC analysis should apply to investments, I presume. The only investments I have are qualified retirement funds and I'm not making withdrawals from them in those years. Since that doesn't contribute to my income and my earned income is stable, how could my standard of living be low in those years?

Hi Chris, If the program has you receiving a low return on your retirement accounts, even before you start withdrawals, it will know that your spending now and when you do withdraw will be lower than would otherwise be true. So it will show a below average level of spending, i.e., living standard.

best, Larry

Larry, I must be missing something. Actual spending in the next few years is almost entirely based on my salary. My historical budget jives pretty well with the suggested standard of living. I'm dis-saving some due to significant special expenses, primarily, college costs. It's the MC forecasts that I don't get.

My current portfolio (again, all in retirement funds) shows a mean and median returns of 13.4 and 10.99, a portfolio ratio and beta of 0.56 and 0.08. I plan to keep that mix for a few years into my retirement, but the MC report projects improvement in the standard of living even before I change to a more conservative mix. Is the initial projected low return just the luck of the draw in Monte Carlo forecasting? Even if so, how do returns on my retirement funds that I'm not withdrawing affect that standard of living? Maybe you just answered that question, but I'm not understanding the point you're trying to make.

dan royer's picture

Chris, I'm not sure but what I think he means is that what we see as living standard is of course connected to how our retirement funds (and regular assets) are doing in the market. So even though you don't start drawing on those returns for say another ten years, the living standard today is of course contingent on the success or failure (upside/downside) of the returns on that money--not just ten years from now--but also this year. If you assume, not using MC, that you earn 8% this year on those funds, you'll see one standard of living project this year through age 100. And if you assume that this year you earn a -15% on those funds, then this of course impacts the total of those funds when you go to withdraw them ten years from now and thus impacts your living standard this year. It's all connected--dynamic programming.

I don't know if that sheds any light or not.

Dan, it's still muddy but it's moot. I know for a fact how much I'll earn, how much I'll invest in retirement funds, what my obligations are, and how much regular savings I have available to help meet my temporarily high special expenses. All of that boils down to my current discretionary spending which, barring loss of job, is predictable.

When I retire and start drawing from my retirement accounts, the basic forecasts by ESP seem reasonable. Lacking much in the way of regular funds, my standard of living changes then. That's okay. The spread of possible results in the MC reports are reasonable, as well. So, from that perspective, I'm good.

I just wish I understood better the mechanism from which ESP draws its conclusions. I don't like black boxes, especially when it comes to my future financial well being. Perhaps your explanation about an imputed effect (so to speak) is the answer.

Thanks for your time.


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