Do I have enough money?
Almost every client has asked some version of this question and addressing it is an important part of what we do as financial advisors.
To do that, we need a model, which we call your Baseline Financial Plan. Like any model, it’s only as reliable as the inputs. “Garbage in, garbage out” as the saying goes. Our model (your baseline plan) consists of three key components:
- A cash flow, which reflects future inflows and outflows based on agreed upon assumptions between us and our clients for items like Social Security, Inflation, health care etc., and which incorporate all known future financial objectives;
- A balance sheet, which should include all the resources that are in place to support that cash flow; and finally
- An output, which analyzes the likelihood of that balance sheet being able to support that cash flow over time.
We think that Monte Carlo simulations provide the best way to generate this output because we don’t know for certain what the future will look like. We need to make assumptions about what to model and importantly, model (and plan for) a range of future outcomes. But obviously, comfort in the tool we use to create the output is going to heavily determine how confident clients are in their answer to the “Do I have enough money?” question.
There are a couple of questions that come up often as it relates to the analysis. They are: 1) can I trust the analysis given the wide range of potential future results? And, 2) does it account for fat tails—or in layman terms, low returns?
The purpose of this post to answer these questions related to our Monte Carlo simulations. But first, let’s take a quick look at why we use Monte Carlo in the first place.