Monte Carlo Simulations: Forecasting Folly?

What happens in Monte Carlo, should stay in Monte Carlo

January 2024. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Financial advisors primarily use Monte Carlo simulations to forecast returns
  • However, this methodology is flawed as it ignores the valuations of asset classes
  • Using capital market assumptions is likely a better approach

INTRODUCTION

The Shanghai Composite Index (SSE) was booming in early 2015, and as it soared, legions of new investors rushed in to try their luck at securities speculation. Although stock bubbles were nothing new, this one had two peculiarities. First, under the regulatory framework, SSE stocks could not rise or fall more than 10% on any given day, which after several months of a bull market, made for some unusual-looking stock price charts. Second, many retail investors focused on buying “cheap” stocks, or those that traded below 20 renminbi (RMB).

Like all bubbles, this one eventually deflated. The SSE plunged nearly 40% between June and September 2015 and taught many novice investors the difference between price and valuation. A stock trading at $5 may be obscenely expensive just as one that trades at $1,000 may be a steal.

While experienced investors understand this intuitively, many financial advisers are guilty of making similar mistakes. On any given day, they meet with prospective and current clients to discuss their financial outlook. Central to these conversations are forecasts — often in the form of Monte Carlo simulations — that estimate the value of the client’s investment portfolio at their prospective retirement date.

Here is why this is a flawed approach and why there is a better way to anticipate future returns.

EXPECTED RETURNS

Thousands of metrics have been tested across time periods and geographies, but there is no evidence that any investor, even those equipped with artificial intelligence (AI)-powered strategies, can forecast individual stock prices or that of the entire market in the short to medium term (read Hitting Home Runs with AI Investing?). If it were otherwise, mutual fund and hedge fund managers would generate more alpha (read