Monte Carlo Simulation

A Monte Carlo simulation is a way to simulate the outcome of an event (from a very simple one with only one variable to a hugely complex one with many different variables) that revolves around the input of one or more random variables. We might try to simulate the future price of an investment by taking historical data on its performance (returns, standard deviations, and other factors) and introduce a random factor to one or more of those factors. As we run the simulation, we might get a price for tomorrow.

Running it again using tomorrow’s just-calculated info might give us a price two days out. Running it over and over again using each output as the input of the next one might give us a projection a month out. Then we’ll start over again from scratch and run it over and over again to the same point. Then again. And again. Eventually we’ll have whole series of projections all slightly different due to our random factors. Taken as a whole they may reveal a pattern or a range of values between which we can reasonably expect the price to be one month out.