Monte Carlo Simulations Explained: Why Average Returns Are a Trap

Relying on averages can be misleading. In many areas of life, the average doesn't reflect the extremes you actually experience. This is especially true in retirement planning.

Most basic retirement calculators are "linear." They assume a constant average return—say, 7%—and draw a smooth, predictable line going up and to the right over time.

But financial markets don't move in a straight line. They experience periods of rapid growth and sudden declines. Planning your retirement based on a steady, unvarying average ignores the reality of market volatility.

This is where Monte Carlo Simulations provide a more robust approach.

What is a Monte Carlo Simulation?

Imagine you want to know if you have enough money to retire.

A standard calculator says: "The market goes up 7% every year. You are fine."

A Monte Carlo simulation says: "Hold on. The market is crazy. Let’s play out 10,000 different versions of the future and see what happens in each one."

• In Future #1, the market crashes the year you retire.
• In Future #2, the market booms for ten years straight.
• In Future #3, inflation spikes to 10%.
• In Future #4, everything is average.

It rolls the dice thousands of times, using real historical data to see how your portfolio holds up against the chaos of real life.

Why Averages Lie: The Sequence of Returns Risk

Here is a concept that keeps financial planners up at night: Sequence of Returns Risk.

It sounds technical, but it’s actually really simple. It just means that when you get your returns matters just as much as what those returns are.

Let’s look at two retirees, Alice and Bob. Both start with $1 million and withdraw $50,000 a year. Both average a 7% return over 30 years.

• Alice gets bad returns early. The market drops 20% in her first two years of retirement.
• Bob gets good returns early. The market goes up 20% in his first two years.

Even though their average return is the same at the end, Alice might run out of money at age 75 because her portfolio took a hit right when she started withdrawing cash. She was selling stocks while they were down, digging a hole she couldn't climb out of.

Bob, on the other hand, ends up with $3 million because his portfolio grew so much in the early years that he could weather any storm later on.

A simple calculator treats Alice and Bob exactly the same. But they lived very different lives.

How the Simulator Works

I built the Retirement Savings Simulator because I wanted something better than a crystal ball.

1. It uses history: We look at what the S&P 500 has actually done over the last century. We know that markets crash. We know they recover.
2. It runs the numbers: When you click "Run Simulation," the tool plays out thousands of different lifetimes for you in a split second.
3. It gives you a probability: I don't tell you "You will have $1 million." I tell you "You have a 90% chance of not running out of money."

Interpreting the "Success Rate"

When you see that percentage on the dashboard, here is how I read it:

• 95% - 100%: You are rock solid. You could probably afford to spend a little more or retire a little earlier. You are over-prepared (which is a great problem to have).
• 80% - 95%: This is the sweet spot. You have a very high likelihood of success. You might have to cut back on spending slightly if the market has a really bad year, but you are generally safe.
• 50% - 80%: You are flipping a coin. You might make it, but you are relying on good luck. I wouldn't be comfortable retiring with these odds.
• Below 50%: We need to change the plan. Save a bit more, work a little longer, or plan to spend less.

Stress-Test Your Retirement Plan

You wouldn't buy a car that hadn't been crash-tested. Why would you build a retirement plan that hasn't been crash-tested?

Don't settle for a calculator that assumes a perfect world. Use the simulator to see how your plan holds up in the real world. If you can survive the "bad" futures, you can enjoy the "good" ones with total peace of mind.