Why Monte Carlo will change the way you make financial decisions and think about scenarios?

Introduction

When you hear Monte Carlo simulation what do you think?

A racing game,

casino game or

a financial decision.

The answer is hopefully the last 2…albeit in the casino it’s not your decision but certainly the houses decision over time for sure.

I assume at this point you want the definition of Monte Carlo simulation. Even some of the most advanced financial modelers are not entirely clear as to what it is mechanically and mathematically.

The official Wikipedia definition is defined as methods with a broad class of computational algorithms that rely on repeated random sampling to obtain numerical results. Their essential idea is using randomness to solve problems that might be deterministic in principle….

Sound easy to understand yes…let me simplify it for you.

Why is it that people just don’t get the power of more than 3 scenarios?

Why is this even important?

Whenever I meet professional finance people of all types and accountants in practice, the most they would think of analysing is 3 scenarios when it comes to “what-ifs” or “modeling”…for those that call it that…. maybe 5, and rarely 10. But never 1000’s.

Rather than having only 3 choices of outcomes imagine what it would be like to run scenarios that are a little closer to real life…isn’t that the whole purpose of doing the model in the first place ??

Now we are talking about more than 1,000’s in some real life cases…..perhaps a lot more.

In reality there are probably millions of different scenarios and outcomes, but let’s just say 1,000 is good enough for now, certainly not 3, 5 or 10.

If only life were as simple as just 3 scenarios.

What do people do today ?

Let me start at the beginning of forecasting 101…which hopefully many would be aware of or at the very least learn from:

1) Set a plan and a somewhat dynamic “budget” let’s say. Call it “what you told the bank” or the “listed equities market” what you guessed the profit would be. Using only 3 scenarios that’s probably what you are doing anyway…yes guessing.

Compared to Monte Carlo simulation where you are doing significantly more advanced scenarios and testing the outcomes, many times over.

2) Once you have collaborated with plenty of stakeholders to come up with the numbers it still takes time just thinking of 3 scenarios in the first place. Organisations move slowly so doing more scenarios means massively more manual work and cost, for little extra perceived value, so they just don’t do many scenarios and often stick with 3 (if you are lucky, sometimes only 1 scenario as the systems can only handle 1 budget).

Imagine for a moment how long it would take to get 10 or 100 scenarios for everyone to agree on….let’s say across 10 or 100 divisions or product owners. Near impossibility.

What could people do instead?

Here is a crazy idea…why not get them together in a room and decide on a range of outcomes between 2 extremes.

Just ask them to pick a range and let the model do the hard work for you. This is known as a simulation, where you are randomly generating the assumptions between outer limits.

How many finance professionals or business partners actually ask their stakeholder for a range.

Most organisation at group level might ask for 3 -10, but never 1000’s of scenarios.

Why is this valuable?

How much more valuable would that conversation be as it allows people to think more like real life, rather than being squeezed into a box of only 3 options?

Also, you will notice that very few accounting-based forecasting software packages (small or larger) can claim proper modelling techniques that do Monte Carlo Simulation…. only Excel at this stage from what I know, happy to be proven wrong.

So, the value of Monte Carlo is that ability to bring forecasts closer to real life. This is something many strive to achieve when building a forecast (ie replicate as close to real life as possible), but of course pretty much most would recognise that it’s difficult to predict the future with absolute precision…this isn’t the point of this article. It’s about getting more accurate than guess work.

Perhaps with Monte Carlo this future is slightly less opaque.

What will people do in the future?

Now take that very same picture of a Monte Carlo simulation and rather than clicking a macro button in Excel to run a simulation, you are Tom Cruise with some cool gloves on in a decision room and you are dynamically swiping your way through financial decisions and simulations….almost like Keanu Reeves in the matrix even!

This is the true future of financial modeling.

We are getting there quicker than you think.