subject: How a Retirement Calculator Models Volatility [print this page] How a Retirement Calculator Models Volatility
This article is in regards to retirement income and retirement modeling. Many people rely on retirement calculators to model their retirement income strategy and determine the possibility of success (success being defined as an income that lasts for the life of the individual receiving it).
A retirement model can be simple or very complex. A simple model would project the income stream based on an average return. This means that each year the return would be assumed to the same! If you are invested in risky asset classes such as stocks, mutual funds, ETFs, and other instuments (that can go up and down by the minute), you cannot rely on a simple model. It would not come close to reflecting reality.
You would need a model that can simulate changes in market value. One method of doing this is called Monte Carlo Analysis. Monte Carlo Analysis is a system that requires random number generation. Luckily, with the advent of the modern computer, this is not a problem. There are all sorts of calulators available that rely on Monte Carlo simulation, and you can even build one in a spreadsheet.
Next, you need a model to test.In the case of a retirement calculator, your model might consist of a hypothetical sum of money that is invested, and subject to an ever-changing market return (this is where the random number generatorcomes in handy). Also, you would have a hypothetical number of withdrawals that are subtracted from the balance over time.
Because of therandom number generator, every time that the calculator is run, the results would be different. Because of this, the calculator needs to be run thousands of times, the results recorded, and then aggregated, to determine the probability of success.
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