The Monte Carlo Model Made Easy
If you’re looking for a strategy to improve the odds in an uncertain market, the Monte Carlo Model is the one for you! This model was born in uncertain times and used in more than just the financing world to solve challenging scenarios.
Keep reading this article to learn about the Monte Carlo model, an analogy to explain it, when to apply it, and how it’s easy to use with Equities Lab.
What is the Monte Carlo Method?
John von Neumann and Stanislaw Ulam invented the Monte Carlo method in the 1940s during WWII. They named it after Monaco because of the location’s affiliation with gambling, which leads right into what the model does.
The Monte Carlo method is based on the probability of outcomes using random variables. The random numbers and data are used to create approximate solutions and predict risks, hence why the method was named after a gambling city.
Although it may seem like a questionable strategy, the Monte Carlo simulation is used not only in finance and investing but also in physics and engineering.
Why is this a good method? It’s an excellent method for approaching challenging, complex problems that are difficult to solve through normal mathematics. It allows for the heavy lifting of trial and error to be taken off the load of those who use it. It might not be your typical data-driven investing, but it definitely owns its place in the financing world.
From Lemonade to Gambling?
Read this analogy to understand how it works!
Barney’s back at it! But this time, he will use the Monte Carlo simulation to predict future revenue for his wildly successful lemonade stand.
Barney wants to predict the revenue he will make in a given week. He has to consider all the elements at play and how those might interact with each other to get a particular outcome.
Here are the factors that Barney is considering;
- Weather (Temperature, sun, rain)
- Local Events/Activities (Near the lemonade stand)
- Types of customers (family, friends, individuals, etc.)
- Customer preferences (small, large, pitcher, etc.)
How will he consider these activities? Adding random variables for those elements to see what is most likely!
- Estimating the weather
- Guessing if there are events or not
- Plugging in amounts of customers by individuals, families, etc.
- Considering potential preferences
Once Barney has his factors and random variables, he runs a simulation! Now it won’t be right the first time, the second time, or even the third time. So Barney runs it 100 times with different variables to see the potential revenue.
After he runs it 100 times, he takes all the results for profit based on the variables, and then for that particular week, he looks at the weather and can make an informed decision ahead of what could happen.
Although this was used for a lemonade stand, the simulation is great for anticipating/considering the risk involved with an investment.
When to Apply the Simulation
The simulation can be applied to uncertain scenarios or elements that are difficult to predict—for example, cash flow, option pricing, and, most significantly, portfolio management.
Portfolio management is the most significant because of the ability to include the factors that a client might be looking into. Some of the factors that could be considered for portfolio management are the following;
- Asset class returns
- Inflation
- Reinvestment rates
- Taxes
Do you want to calculate that all by yourself, or would you rather use random variables that could assist in providing a viable answer? Maybe Monte Carlo is the factor-based investing you’re looking for!
Using Monte Carlo with Equities Lab
If you have access to Equities Lab’s software, then you are capable of incorporating a Monte Carlo simulation into your investment strategies. By searching Monte Carlo in the tools menu, you will see at least two results under the operators’ section (way easier than Excel, if you’ve ever tried).
The first result, “monte carlo range,” and the second, “monte carlo set,” allow users to analyze data using the Monte Carlo method. The below image is the “example monte carlo set” for the purpose of showing the potential information that could be recognized by using this method.
Try out the Monte Carlo simulator today by predicting potential success and, the even scarier part, nearly every risk! You’ll never know EVERY outcome until you try this method.
