Hidden Value is a column in ThinkAdvisor where Joe Elsasser, CFP®, answers common questions with insights advisors and their clients may not have considered. This week he takes a closer look at Monte Carlo simulations.
Many advisors use Monte Carlo simulations to demonstrate to clients the range possible outcomes. However, Monte Carlo simulations neglect to consider the consequences of failure, which can be dangerous for clients and their retirement income planning. Here's an excerpt:
"If the focus of financial planning is to move people to the best possible decisions, the industry needs to recognize that “a probability of success” is really a poor mechanism to do so. People experience events, not probabilities. More importantly, people can’t visualize probabilities, but they can visualize events."
It is crucial for advisors to consider the consequences of failure a well as the probability of success. Instead of Monte Carlo simulations, Joe suggests a lifetime financial planning processes that systematically revisits a reasonably conservative expected path, and in addition, considers multiple possible personal and economic futures that could create dramatically different results.
"I would argue that the central dashboard for financial planning decision-making should include a base case with a reasonable, but realistic, estimate of long-term returns. Couple this with a variety of stress tests that demonstrate the impact or consequences of a risk event with clear explanations of the base case and the risk events tested. If there is a realistic possibility of failure, then we should discuss the consequences of that failure and adjust the plan to bring those consequences into an acceptable range."
Read the ThinkAdvisor article in its entirety.
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