Odds-On Imperfection: Monte Carlo Simulation (WSJ article)

Beliavsky · 2009-05-04T01:29:09+00:00

by ELEANOR LAISEWall Street JournalMay 2, 2009 is no standard Monte Carlo approach, but the method is nothingnew. It was used during World War II to help develop the atomic bomb.By the late 1990s some financial-services firms, like T. Rowe PriceGroup Inc., had introduced Monte Carlo tools aimed at individuals.If one had asked a financial adviser 18 months ago for retirement-planning guidance, there is a good chance he would have run a "MonteCarlo" simulation. This calculation method, as it is commonly used infinancial planning, estimates the odds of reaching retirementfinancial goals.But there is little chance your Monte Carlo simulation, named for thegambling mecca, would have highlighted a scenario like the marketslide just seen. Though these tools typically run a portfolio throughhundreds or thousands of potential market scenarios, they often assignminuscule odds to extreme market events. Yet these extreme events seemto be happening more often.Some industry participants and academics are pushing to improve theMonte Carlo tools' ability to highlight the risk of major marketslides.My comment: the standard deviation of daily stock market returnsvaries drastically over time, by perhaps a factor of 8 -- annualizedvolatility of daily returns has ranged from 10% to 80% (experienced inOctober and November 2008), as is reflected by the VIX index. To bemore realistic, Monte Carlo simulations should incorporate "stochasticvolatility".

May 04, 2009 20 Replies

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Pierre Asselin 17 years ago

Some do. See equation (8.5) at

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Does that make them any good ? It's been a while since I read the paper but IIRC the author gives the appropriate perspective.

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Odds-On Imperfection: Monte Carlo Simulation (WSJ article)

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