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Monte Carlo Simulations

Monte Carlo is a technique to calculate the uncertainty in a forecast of future events. It assumes you are using some kind of mathematical model. Financial planning abounds with such models.

Instead of using a single value for each variable in a model, say investment returns, it uses many values. A Monte Carlo "engine" runs the model over and over again, each time using a different value for each of the variables in the model. Each run is called a "trial". The outcomes are tabulated, and after a large number of trials, the forecast is shown not as a single value, but as a range of values. In other words, the uncertainty is explicit.

 The selection of the value for the variable for each trial is random. But, the permitted values of the variable are not random. They are carefully constructed using the best knowledge as to how the variable behaves.

The future is uncertain, therefore the assessment should take into account the uncertainty. What are likely future investment returns, inflation, etc.?

 Monte Carlo is one such technique that greatly increases our grasp of the consequences of uncertainty.

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