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Real Rate of Returns in Monte Carlo simulations leads to far worse outcomes

 

Greg Howard
(@howard230)
New Member Customer
Joined: 8 months ago
Posts: 2
Topic starter  

I've struggled over the years with the ROR for my 8 asset classes in Pralana Gold. I understand the concept but given the supposed overvaluation of almost all asset classes right, projected Monte Carlo returns are all quite low for ROR. But (a big but), these tools with projected returns are normally not really looking past 10 years, let alone the 40 to 45 I am modeling. My problem is that I've used the current projected conservative ROR for all my asset classes which ends up giving me a far more pessimistic Monte Carlo outlook for my future versus Historical returns, Bear Market Analysis returns or the outlook in other calculators like Fidelity and Firecalc.

One tool that does at least project to 30 years is this one: https://www.blackrock.com/institutions/en-us/insights/charts/capital-market-assumptions

I'm curious if others use the same conservative RORs by asset class and do their Monte Carlo results look much worse than Historical and even "Bear Market Analysis" returns? My overall ROR for the 40 years using these estimates is 2.73%.


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Pizza Man
(@giovanelli766)
Active Member Customer
Joined: 8 months ago
Posts: 10
 

I also model out 40 years and my Monte Carlo results are always worse then Historical (backtesting) returns. Measuring risk is at the heart of retirement planning and these two forms of computer simulations are the most common (with bootstrapping a third). However, I don't put much faith in Monte Carlo analyses for retirement planning. Backtesting is based on real market data, Mote Carlo randomly create data. Using Monte Carlo for retirement planning is only as good as the underlying model of the markets, which is problematic. There are no agreed standards for modeling markets in a realistic way. Backtesting takes into account asset allocation, return disposition, sequence of returns, volatility, inflation, momentum, etc. Looking at momentum, the stock market has a tendency to drop quickly and by large amounts, but then take a lot longer, sometimes years, to come back. This is one reason that annual rebalncing is not a good idea (but that's another discussion).

Pizza Man


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Bill Hines, Retirement Planner
(@hines202)
Trusted Member Customer
Joined: 8 months ago
Posts: 60
 

There are good arguments for not using historical backtesting as well (see other threads on monte carlo vs historical on this board). For one, as we've learned from past economic events and put in checks and balances to prevent those from happening again, they become moot. We've recovered very quickly from the last two downturns using this knowledge and techniques (but let's not get overly optimistic and assume every recovery will be quick).

That said, it's interesting and fun to see how your circumstance would have fared if for example, you retired in 1965, which is arguably the worst year to retire in history given all that transpired over the following years. Some historical tests go back to eras where economic markets and policy bear no resemblance to today.

I do have questions about the different monte carlo simulations - do they model typical economic trends (peak, expansion, trough, recession, etc) or just competely random ups and downs?

Bill Hines
Investment Advisor/Financial Counselor/Retirement Planner
Emancipare Investment Advisors LLC
https://emancipare.com
bill@emancipare.com


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Stuart Matthews
(@smatthews51)
Member Admin
Joined: 12 months ago
Posts: 215
 

@hines202 Bill, PRC's Monte Carlo simulations are based on completely random up's and down's (based on a normal distribution and the user-specified mean and standard deviation).


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Pizza Man
(@giovanelli766)
Active Member Customer
Joined: 8 months ago
Posts: 10
 

The last two down turns are good examples of why Monte Carlo does not work well for retirement planning. Yes, check and balances were put in place during the last century, but that did not stop the 2008 global market melt down. Humans have an amazing ability to get around check and balances (and rules) - subprime mortgage anyone? Once in a century pandemic (made worst by human behavior) causing global market drop, albeit short term. The point is Monte Carlo does not handle these types of events very well. Historical back testing takes into account human lunacy, which has not changed since stock markets were first invented, so using as much historical data as possible will give you your worst case outcomes. I am not saying don't use Monte Carlo analyses, the more ways of looking at things the better (nothing is perfect) but I would not solely rely on it. Good discussions, keep it going!!!!!


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Greg Howard
(@howard230)
New Member Customer
Joined: 8 months ago
Posts: 2
Topic starter  

I can tell you that my Monte Carlo results are far worse than all of the Bear Market simulations included in Pralana (great feature). I may just be far too pessimistic in my ROR for all my asset classes. I can't believe that the next 30 to 40 years are going to be worse than the 2.73% ROR I'm modeling, but am curious what others are using for their ROR for their asset classes. I am using many resources, including the ones Stuart recommends, that are attempting to predict future real rates of return and standard deviations, but they rarely go past 10 or 20 years. I will be overjoyed if the Historical returns are accurate for my scenarios.


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