Monte Carlo Simulation - Are Your Boots In The Water?

Overview: Monte Carlo simulation is a mathematical technique that uses probabilities of occurrences to generate a range of possible answers to problems. This article talks about an incident that where software companies are touting its benefits and the advisor community is locked in a debate as to the mathematical accuracy of the models being used by investors and advisors alike. It gives the description of the boots, represent the "client variables" of draw-down, equity allocations and the like, weather represents "market variables" and rainwater represents the "current market environment". When considering each time the wire was touched, the mathematician derived a 5% probability of shock or a 95% probability of success. When touches were counted only when rainwater covered the boots, the electrician derived a 100% probability of shock. If one begins drawdown in a market priced at 30 times earnings, the boots may be in the water. Just as the 5%, electrical shocks occurred 100% of the time when the environment included rain, so too could the 5% investor shock occur with a much higher probability than Monte Carlo simulations suggest.

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Format: HTML | Date: Jan 2003 | Pages: 1