One common goal most of us share is that one day we would like to have sufficient resources so that we never again have to work for money.  We might still choose to work, but it would be by choice, not by necessity.  This point in time is known as “financial independence.”

Financial independence is unlike most other life or financial goals in that it can be difficult to say when we have arrived.  If you have a goal to educate your children, you clearly know when you have completed that goal.  If you have a goal to run a marathon, you know you have arrived when you cross the finish line.  Financial independence is more elusive.  How do we know when enough is enough?  Moreover, how we determine the mile marker of the present moment? 

In the early years of financial planning, we would run extensive sets of numbers, and use a fixed, constant rate of return to determine whether a client had sufficient assets to “retire.”   The problem with this approach is assuming a future annual fixed rate of return of 6% or 8%, or even 10% for more aggressive clients is far from the reality of the capital markets. 

While this method was better than not planning at all, it left much to be desired, as rarely did anyone experience the same rate of return year after year.  It gave clients a false sense of security.  And they were immediately faced with the disconnection of their financial plan analysis and the reality they witnessed when opening their brokerage statements.

What this process failed to address was the biggest fear every retiree faces.  Will I run out of money? 

Investment returns have randomness and uncertainty associated with them just like gaming.  There is a risk that one might win or lose.  Faced with the same scenario, casinos developed Monte Carlo, a mathematical methodology designed to ensure that they always made money over a period of time.

Enter the use of Monte Carlo simulation into financial planning.  Just as the casinos always make money in the long run, investment asset classes such as stocks and bonds also make money in the long run based on historical data.  Using Monte Carlo simulation in your financial plan accepts the reality that capital market returns are uncertain, and this methodology gives a very predictive range of possible outcomes.

It is not unusual to use Monte Carlo simulation in a financial plan, and to have the results vary from going broke to a $4 million dollar net worth at a specified age.  While the range of results can be challenging to wrap your mind around, the moment anyone looks at the numbers, they feel comforted knowing that this is a more accurate prediction of their possible future than the old methodology of simply running projections using a constant and conservative rate of return.

But what the Monte Carlo simulation really gives us is a mile post and a comfort zone.  It allows us to run 1000 possible sets of returns over a client’s lifetime and to give probabilities for those outcomes to occur.  The analysis gives us a comfort level of our possibility of success using historical capital market returns.

For example, based on a set of objectives, a particular strategy can conclude that you will achieve your goal with 80% confidence.  This means your chances are eight out of ten that you will have enough money to live out your life in the fashion you desire, and two out of ten that you will run out of money.  As the client, you choose the level of certainty. 

Financial planning at its core is about choices.  The planning process, using Monte Carlo simulation can give you clarity about the consequences of your choices.  Want to save less?  Want to retire earlier?  Want to leave a legacy for your family?  Planning allows you to contrast and compare your options and choices. 

As life happens, you can adjust your plan.  You may generate better returns than expected; your child may get a college scholarship; you may receive an inheritance; you may decide that you want to retire with more money, and so on.  Because computers can analyze data repeatedly and effortlessly, you can adjust and run any number of “what ifs” until you find your comfort zone.

But the best part of using Monte Carlo simulation in your financial plan is that you know when you have arrived.  Using your plan data, you can say, “I have enough.” I can enjoy my financial independence with peace and tranquility.    

For more information on Monte Carlo simulation, www.financeware.com or simply do a google search and read a wide array of articles on the subject.

The main reason most people fail to reach their financial goals is that they fail to plan.  Planning includes taking inventory of where you are, clearly identifying your goals, and projecting those results into your future.  Challenging?  Yes.  Simple?  No.  But the freedom of financial independence is worth the effort.