Monte Carlo Simulations Are Not a Bad Bet

(MoneyWatch)  When determining your investment plan, you or your advisor may have used Monte Carlo simulations to determine the best asset allocation for your portfolio. Recently, those programs have come under fire due to market events from the past several months. You should know that Monte Carlo simulation programs are still valuable tools for constructing your portfolio.

Monte Carlo simulations take inputs about your financial situation -- including your age, assets and expected retirement contributions -- and generate several hundred potential market scenarios. These results are aggregated to show you the likelihood of your investment plan achieving its goal -- say, leaving money to your heirs or simply not running out of money in retirement.

It is important to note that these simulations are a tool used in creating an appropriate investment plan, and aren't meant to reassure you that your plan is guaranteed to work. Wall Street Journal reporter Eleanor Laise recently noted that "given the events of the past couple of years, it appears that the models often gave big institutions, as well as small investors, a false sense of security."

Of course, Monte Carlo simulations aren't perfect. They assume normal return distributions when we know extreme returns occur more frequently than should be expected.

Second, the historical data used to estimate returns, risk, correlations, etc., can look quite different from what happens in the future. Just because something hasn't happened doesn't mean it can't or won't.

Third, the models also assume you won't take any actions along the way to improve your odds of success, such as cutting discretionary spending. If that's the case, the Monte Carlo simulation overstates the risks.

The bottom line is that Monte Carlo simulations are still valuable tools. However, we shouldn't treat them as "science," but more as art. It's also important to understand their limitations, and that investors who have more options, such as a second home they can sell, can take more risk. On the other hand, those that have limited or no options should be more conservative.