Stochastic Modeling: The Basics
By Glenn G. Kautt, CFP, EA
The Monitor Group

In the realm of retirement planning, professionals have many different tools at their disposal to help clients plan for their long-term futures.  But only one method of analysis provides realistic results: stochastic modeling.  This method lends a great deal of sophistication to the planning process when compared to deterministic models (or “spreadsheet” analyses) that require you to make many assumptions about your financial future.   Stochastic simulation takes random elements into account when forecasting future wealth.  Injecting uncertainty into the model adds reality to the outcome and helps you understand more about which factors impact outcomes.  In giving planners the ability to more realistically forecast the future, stochastic modeling helps clients manage the present. 

Accept the Unexpected
Specifically, stochastic simulation models identify and use inputs whose future values may change.  These variable inputs, or pieces of data, can include such information as amounts of spending, inflation, taxes and investment return, as well as probable personal longevity.  Once the inputs are identified, the model asks for the type and amount of uncertainty associated with each one.  Because the uncertainty of each factor must be explicitly considered, simulation modeling forces both the client and planner to quantify each element of risk/uncertainty.  By considering and quantifying the variability of each input factor, the planner develops a “feel” for how the variability of each input can impact the future outcome.

As a result, the modeling process shows how making different personal decisions in the present will impact the probability of outcomes.  This is an extremely important feature of stochastic modeling, because it’s something deterministic models cannot do.

By showing the consequences of making different personal choices, simulation modeling helps people make more informed decisions.  For example, one model result might be as follows: “You have a 20 percent probability of running out of money after retirement given the current inputs.”  This result would give you enough information to consider ways to modify your plan to achieve a different result.

The value of stochastic simulation modeling increases when the range of uncertainties becomes larger, because it helps to develop a more complete picture of the future rather than just a static number.

Use Your Superpowers
You may have watched a TV show that focused on the future, such as Quantum Leap, Early Edition or any number of episodes from The Twilight Zone.  In a typical Early Edition episode, the main character picks up the local newspaper from his doorstep.  Here’s the twist: The newspaper is from the next day.  For example, it’s Monday morning when he receives the Tuesday paper and reads about events that haven’t occurred yet.

The hook for the show is that the main character becomes a hero because he stops bad things he reads about in the paper from happening, along with the inevitable excitement and cliff-hanging suspense.  This show and all the others like it are pure fiction.  Yet they are entertaining, and getting a paper from one day in the future presents intriguing possibilities.

With our planning models, we are trying to see the future by mathematically modeling probable outcomes.  Can seeing the future this way truly improve it in real life, as it does on Early Edition?  The answer is yes because there is a significant similarity between the fictional TV show’s theme and your future.  The main character sees the future perfectly through the newspaper stories – and does something about the outcome.  In your case, modeling the future gives you a range of possible outcomes based on your current situation, actions and a set of assumptions about future events.  It tells you what could happen depending on what you do about it.  This is incredibly useful!

Using the modeling tool, you and your planner can actually see the impact current decisions have on future outcomes.  Knowing this, you can modify your actions accordingly to help assure a high probability of reaching your future financial objectives.  Here’s something I’ll bet even your math teachers didn’t tell you: Sophisticated statistical calculations in the form of stochastic modeling can actually improve your future.

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Glenn Kautt is President of The Monitor Group, Inc., a fee-only financial planning firm located in the Tyson's Corner area of McLean, Virginia. As a nationally recognized wealth management firm, The Monitor Group provides investment and financial planning services to more than 190 high net worth client families in Northern Virginia, Maryland, Washington, DC and across the country. Click here for more information about Glenn and The Monitor Group Inc.

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