One great tool for assessing the probability of risk and future success is the Monte Carlo simulation. This is true in both chess and personal finance.
What is a Monte Carlo simulation, and how can it help you plan ahead?
No one knows the future
A Monte Carlo simulation is a computerized mathematical algorithm that builds models of possible outcomes and probabilities that may occur. It was first invented during World War II by scientists working on the atom bomb and was named after Monte Carlo, the capital of Monaco, which is famous for its casinos.
Monte Carlo simulation featured in high level chess programs (like this popular chess software) assesses the risks and probabilities of using various openings and moves. While you can’t predict the future, using the Monte Carlo simulation to play out each possible move in thousands of different iterations can give you an idea of which path has the greatest odds of success.
Use Monte Carlo simulations to assess your asset allocation
Monte Carlo simulation is also applied to financial planning. While past performance is not a guarantee of future returns, Monte Carlo simulations can determine – based on a very large number of tests – the probability of achieving certain outcomes using real past historical data.
With a database of historical asset returns, Monte Carlo simulation programs can look at specific asset allocations (i.e., 30% U.S. stocks, 25% foreign stocks, 40% corporate bonds, 5% cash) and simulate how that asset allocation would perform over a randomized assortment of market conditions. Plug your actual allocation into the system, or test any model you want, and have the computer analyze thousands of possible financial lives. Knowing how your future might look on all those different possible paths could help you to make wise decisions.
To find out more about Monte Carlo simulations and how they can help you plan your finances, watch the seven-minute video here.
Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You a Grandmaster of Investing, is an avid chess fan, international investment advisor and Certified Financial Planner.TM