How to Talk to Clients about Monte Carlo Analysis

Talking to clients about a Monte Carlo analysis can be tough. Most clients, and frankly a lot of advisors, don’t really understand what the results actually mean. While it helps to understand the nitty-gritty aspects of the math, the basics are pretty easy to understand. Plus, if you find yourself talking to a client about the distribution curve you use to generate your returns, you’ve lost most clients.

At it’s heart Monte Carlo analysis is about measuring risk, and the client conversation is about tradeoffs.

What does risk actually mean?

Risk is a tricky subject. It’s one of those things that everyone “knows” what it is, until they try and describe it. One of an advisor’s most important jobs is to work to understand what risk actually means to each client. Often people talk about risk and investment standard deviation as if they are the same thing. At best standard deviation is a proxy for certain types of risk, but there are a lot of different types of risk.

Standard deviation can tell you a lot about cocktail party or neighbor risk, but it can’t tell you much about the risk that is most important to your clients. For most clients, the thing they are most worried about, when you strip everything else away, is if they will be able to accomplish their goals. If you start breaking everything down, most client worries come down to this. This is what a monte carlo based financial plan is designed to address.

Types of Risk

There are a number of sources of risk that play into this, but those are subsumed into the bigger question of “Will I be ok? Will I be able to do what I want?” The monte carlo analysis is able to answer that question by understanding some of the underlying issues, and assuming that you can manage the rest. There are really two types of issues in play here, and they can be broken down into two main categories: market risk, and client risk.

Market risk is basically anything that the client cannot control. A monte carlo based financial plan will manage risks by modeling a large number possible return scenarios, and simply seeing what happens.

Client risk is trickier. This is everything that the client can control. This is their neighbor talking about the hot stock that their broker turned them on to, or the client panicking at exactly the worst time (going to cash on March 9, 2009…), or simply not following the plan and either saving too little or spending too much. This is on you as the advisor. A financial plan, of any sort, assumes that your clients stay in their seat, and do what they say they are going to do. If this is not the case, then it doesn’t matter how great the plan is, it doesn’t really mean anything.

What all of this means is that a monte carlo based financial plan will be able to help you understand how certain types of risk will impact the client. How you communicate this with the client is obviously entirely dependent on what matters to them. But the one constant is that monte carlo analysis is designed around looking at the tradeoffs between different options.

Considering the Tradeoffs

Every client is different, and there is no right answer. Just like everything in planning, you need to focus on presenting options, and looking at what the tradeoffs are. For instance, if a client takes more investment risk they might be able to save less, or simply have a plan with a higher probability of success. However, when things go bad they will really go bad. Every client will look at this situation differently, and it’s your job to help them understand the tradeoffs and make the right decision for them.

For most clients you’ll want to present different options if you’re creating a plan. From there you can discuss the how they are different and what those differences mean. Some clients might want an aggressive plan with a high probability of success, and accept the downside risk that accompanies that. Other clients will prefer the conservative plan that doesn’t have as high a probability of success, but minimizes the possibility of an ugly outcome. What matters is that you find the plan that makes sense for your client. If they believe in the plan and are comfortable with it they are much more likely to stick with the plan (and you.)

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