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Confidence Bands: Next-Generation Monte Carlo

Jun 21, 2012 Marc Odo

One of the problems with traditional Monte Carlo projections is that it is very iterative process. After establishing the investor’s wealth goals and cash flows, a single portfolio with a forecasted return and risk is chosen. The Monte Carlo process is run and thousands of possible outcomes are calculated. The probability of achieving the client’s goals is presented- for that one portfolio. If the probability of that portfolio reaching the goals is unsatisfactory, it’s back to the drawing board and the whole process is repeated for a different portfolio. There is a lot of trial and error before the “best” portfolio is identified.

Zephyr’s solution is Confidence Bands. With a single click in AllocationADVISOR, users can run Monte Carlo analysis for the entire efficient frontier, from the most conservative portfolio to the most aggressive. This creates a second curve, a “probability curve” underneath the efficient frontier. As the user cruises the efficient frontier from the conservative end to the aggressive end one can quickly identify the single portfolio that has the highest probability of achieving the client’s goals.

In addition to identifying the “sweet spot” on the efficient frontier, Confidence Bands has some other interesting features. One will often see the probability of reaching the client’s goals peak midway through the efficient frontier, but then start to decrease with the more aggressive portfolios. This makes sense, as at a certain point an incremental risk is actually detrimental to reaching the goals. In other scenarios one might see the probability curve never reach an acceptable level of success. This is actually quite useful in communicating to a client that their goals are unreasonable. One could invest in the most conservative or most aggressive portfolio, or at any point in-between, and the likelihood is that the goals will not be met. This creates the opportunity to discuss setting more reasonable goals.

A more complete description of Confidence Bands is available in this case study. Also, feel free to contact our support desk at 1-800-789-5323 for more information.

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