Monte Carlo Simulations-now recognized as understating risk

[unclemick]

Sooo - like er ah 'mentioned' over at the Bogleheads - how do you say Pssst- Dividends in Norwegian? Better than beer in Austrialian.

I could have said pssst Wellesley. But this forum has a lock on the good stuff.

In hard times nailing down some income is sometimes better than over trying to catch inflation.

heh heh heh - remember what S.I. Hayakawa said math models are not always stocks that pay dividends. ok ok so he said something else. .

[. . . Yrs to Go]

I guess that's it for the Early Retirement Forums.

Please turn out the lights if you're the last one to leave.

[Maurice]

Quote:

Originally Posted by ziggy29 In reality, Monte Carlo can only "estimate" or "simulate" risks that have already occurred. If you understand it in THAT context, with the understanding that the future may not resemble the past, it is likely prudent to add a "margin of safety" to their estimates to account for the potential future scenarios that Monte Carlo can't predict.

Not really, MC analyses use a stochastic model that doesn't bear any relation to historical data. Depending on the model used, you could simulate a world with much fatter tails than anything we've experienced, or vice versa.

[Bikerdude]

Quote:

Originally Posted by Maurice Not really, MC analyses use a stochastic model that doesn't bear any relation to historical data. Depending on the model used, you could simulate a world with much fatter tails than anything we've experienced, or vice versa.

That was my understanding of MC simulation. This is why they say 90% success rate is pretty good on MC because of all the "end of world" scenario's included, that while possible, are not probable.

[samclem]

Quote:

Originally Posted by Bikerdude That was my understanding of MC simulation. This is why they say 90% success rate is pretty good on MC because of all the "end of world" scenario's included, that while possible, are not probable.

You don't really know if 90% success is good or not unless you know about the underlying data being used. It would be easy (though irresponsible) to have an assumed data set that was more optimistic (i.e. fewer very bad years) than those already seen in the real world, in which case even 100% success could be produced by a really bad portfolio.

It's all about the "fattness" of the tails of the distribution.

[ziggy29]

Quote:

Originally Posted by Maurice Not really, MC analyses use a stochastic model that doesn't bear any relation to historical data. Depending on the model used, you could simulate a world with much fatter tails than anything we've experienced, or vice versa.

This can be true but I think it muddies the waters even more. How do we know how to assign the probability of something that hasn't happened in the modern history of the developed markets?

I think trying to use MC for anything more than seeing how you would fare under the universe of actual results is about the best we can hope for, and then add a bit of a margin of safety that might help increase survivability through unprecedented future market environments.

[Bikerdude]

Quote:

Originally Posted by samclem You don't really know if 90% success is good or not unless you know about the underlying data being used. It would be easy (though irresponsible) to have an assumed data set that was more optimistic (i.e. fewer very bad years) than those already seen in the real world, in which case even 100% success could be produced by a really bad portfolio. It's all about the "fattness" of the tails of the distribution.

That's the general complaint about MC simulations.