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Monte Carlo—Not Just a Casino

But how can you know if your cash flow goal is reasonable? A good tool professionals often use is a Monte Carlo simulation. A Monte Carlo simulation approximates the probability of certain outcomes using random variables run in multiple iterations.

For example, let’s say you want to calculate the odds of flipping five coins simultaneously, all landing on tails. The random variable here is heads versus tails. In the simulation, five coins would be flipped to see if all five came up tails. The analysis would run this over and over (multiple iterations) and report the results—i.e., how many times all five landed on tails, what the biggest winning and losing streaks on average were, how many times in a row you could get five tails, etc. The more iterations run, the better and more scientific the findings.

In my view, when measuring investment results, it’s better to do a bootstrap analysis—another form of Monte Carlo. But instead of using a random number generator for hypothetical results within a specified range, as a traditional Monte Carlo does, the bootstrap randomly pulls from a pool of actual data to better approximate “real-life” situations.

You can build your own Monte Carlo simulation—Excel makes it (relatively) easy for you, plus you can buy plug-ins to make it easier. A basic Internet search (“Monte Carlo Excel”) should yield plenty of help—or any college student who has taken statistics can probably help you. The hardest part will probably ...