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Monte Carlo Tools Blamed for Practitioner's Folly

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Joined: 20 Feb 2009
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PostPosted: Wed May 06, 2009 9:53 am GMT    Post subject: Monte Carlo Tools Blamed for Practitioner's Folly Reply with quote

I'd say almost 100% of Financial Planners have no idea what they are doing, and unfortunately this comes up during extremely volatile periods when their client portfolios blow up 'unexpectedly' due to 'rare events' which their Monte Carlo simulator failed to predict. Of course, Monte Carlo simulation is the best method for stress-testing portfolios. However, most of these are designed by people who have no idea that the world is not Gaussian. And even if there was a way to program in a power law (i.e. the real world stock market behavior) into one of these simulators, because of the nature of the reality (i.e. we never know what the peak loss is and where it will strike) you would still need to understand how to use the resulting simulation results and be aware that you can not feel safe just because you got a simulation to tell you that you are safe. This is why risk mitigation is the most important aspect of portfolio management. An average investor is even less prepared for the reality, and will most likely do one of two things:

1) Bail out this time (i.e. lock in losses), and try to play catch up by trying to time the market
2) Never enter the market again (keep all the money in cash, and ensure that he'll never have enough money)
3) Keep the money in the same risky assets and get hit by the next downswing when the money is needed
4) Go to a financial planner who would do either 1) or 3) above, and basically not improve the situation one bit
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