Financial planning software comes in a variety of packages. Some are more granular or detailed than others and some are more comprehensive. Also, most plans today utilize Monte Carlo simulation (MCS) to account for the uncertainty inherent in many assumptions. In this post, we’ll discuss the two assumptions on which it is most important to incorporate MCS.
The Most Important Assumptions
As any planner will agree, a thorough and comprehensive financial plan requires a number of inputs. Some inputs also have a greater influence on the results than others but all are necessary to create a thorough analysis of a client’s financial situation. However, amid the myriad of assumptions required to create the plan, there are two assumptions which are most significant. In other words, it’s more important to use MCS on these two assumptions than it is on others. They are investment returns and expenses.
Before proceeding we should define these terms: risk and uncertainty. We’ll define risk as the possibility of an undesirable outcome, while uncertainty is that something unknown may happen, good or bad. Where the first is a negative outcome, the second is simply not knowing if the outcome will be good or bad. When I first set out to determine the assumptions on which incorporating MCS is most important, I adhered to the following process:
Step 1: Input all assumptions
Step 2: Add MCS on all assumptions which contain uncertainty
Step 3: Run the simulation
Step 4: Save the results