12/29/2020 Using Monte Carlo Analysis to Estimate Risk

CORPORATE FINANCE & ACCOUNTING FINANCIAL ANALYSIS

Using Monte Carlo Analysis to Estimate Risk

By ROBERT STAMMERS | Updated Aug 6, 2020

The Monte Carlo model makes it possible for researchers from all different kinds of professions
to run multiple trials, and thus to define all the potential outcomes of an event or a decision. In
the finance industry, the decision is typically related to an investment. When combined, all of
the separate trials create a probability distribution or risk assessment for a given investment or
event.

Monte Carlo analysis is a kind of multivariate modeling technique. All multivariate models can
be thought of as complex illustrations of "what if?" scenarios. Some of the best-known
multivariate models are those used to value stock options. Research analysts use them to
forecast investment outcomes, to understand the possibilities surrounding their investment
exposures, and to better mitigate their risks.

https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 1/8
12/29/2020 Using Monte Carlo Analysis to Estimate Risk

When investors use the Monte Carlo method, the results are compared to various levels of risk
tolerance. This can help stakeholders decide whether or not to proceed with an investment.

KEY TAKEAWAYS
The Monte Carlo model makes it possible for researchers from all different kinds of
professions to run multiple trials, and thus to define all the potential outcomes of an
event or a decision.
When employing the Monte Carlo model, a user changes the value of multiple variables
to ascertain their potential impact on the decision that is being evaluated.
In the finance industry, the decision is typically related to an investment.
The probability distributions produced by a Monte Carlo model create a picture of risk.

Who Uses Multivariate Models

https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 2/8
12/29/2020 Using Monte Carlo Analysis to Estimate Risk

Multivariate models—like the Monte Carlo model—are popular statistical tools that use multiple
variables to forecast possible outcomes. When employing a multivariate model, a user changes
the value of multiple variables to ascertain their potential impact on the decision that is being
evaluated.

Many different types of professions use multivariate models. Financial analysts may use
multivariate models to estimate cash flows and new product ideas. Portfolio managers and
financial advisors use them to determine the impact of investments on portfolio performance
and risk. Insurance companies use them to estimate the potential for claims and to price
policies.

The Monte Carlo model is named after the geographic location, Monte Carlo (technically an
administrative area of the Principality of Monaco), that has been made famous by its
proliferation of casinos. [1] [2]

https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 3/8
12/29/2020 Using Monte Carlo Analysis to Estimate Risk

Outcomes and Probabilities

With games of chance—like those that are played at casinos—all the possible outcomes and
probabilities are known. However, with most investments the set of future outcomes is
unknown.

It's up to the analyst to determine the outcomes as well as the probability that they will occur. In
Monte Carlo modeling, the analyst runs multiple trials (sometimes even thousands of them) to
determine all the possible outcomes and the probability that they will occur.

Monte Carlo analysis is useful because many investment and business decisions are made on
the basis of one outcome. In other words, many analysts derive one possible scenario and then
compare that outcome to the various impediments to that outcome to decide whether to
proceed.

Pro Forma Estimates

Most pro forma estimates start with a base case. By inputting the highest probability
assumption for each factor, an analyst can derive the highest probability outcome. However,
making any decisions on the basis of a base case is problematic, and creating a forecast with
only one outcome is insufficient because it says nothing about any other possible values that
could occur.

It also says nothing about the very real chance that the actual future value will be something
other than the base case prediction. It is impossible to hedge against a negative occurrence if
the drivers and probabilities of these events are not calculated in advance.

Creating the Model

Once designed, executing a Monte Carlo model requires a tool that will randomly select factor
values that are bound by certain predetermined conditions. By running a number of trials with
variables constrained by their own independent probabilities of occurrence, an analyst creates
a distribution that includes all the possible outcomes and the probabilities that they will occur.

There are many random number generators in the marketplace. The two most common tools
for designing and executing Monte Carlo models are @Risk and Crystal Ball. Both of these can
be used as add-ins for spreadsheets and allow random sampling to be incorporated into
https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 4/8
12/29/2020 Using Monte Carlo Analysis to Estimate Risk
be used as add ins for spreadsheets and allow random sampling to be incorporated into
established spreadsheet models.

Correct Constraints
The art in developing an appropriate Monte Carlo model is to determine the correct constraints
for each variable and the correct relationship between variables. For example, because portfolio
diversification is based on the correlation between assets, any model developed to create
expected portfolio values must include the correlation between investments.

In order to choose the correct distribution for a variable, one must understand each of the
possible distributions available. For example, the most common one is a normal distribution,
also known as a bell curve.

Normal Distribution and Standard Deviation

In a normal distribution, all the occurrences are equally distributed around the mean. The mean
is the most probable event. Natural phenomena, people's heights, and inflation are some
examples of inputs that are normally distributed.

In the Monte Carlo analysis, a random-number generator picks a random value for each variable
within the constraints set by the model. It then produces a probability distribution for all
possible outcomes.

The standard deviation of that probability is a statistic that denotes the likelihood that the
actual outcome being estimated will be something other than the mean or most probable
event. Assuming a probability distribution is normally distributed, approximately 68% of the
values will fall within one standard deviation of the mean, about 95% of the values will fall
within two standard deviations, and about 99.7% will lie within three standard deviations of the
mean. [3]

This is known as the "68-95-99.7 rule" or the "empirical rule."

Who Uses the Method

Monte Carlo analyses are not only conducted by finance professionals but also by many other
businesses. It is a decision-making tool that assumes that every decision will have some impact
on overall risk.

Every individual and institution has a different risk tolerance. That makes it important to
calculate the risk of any investment and compare it to the individual's risk tolerance.
https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 5/8
12/29/2020 Using Monte Carlo Analysis to Estimate Risk

The probability distributions produced by a Monte Carlo model create a picture of risk. That
picture is an effective way to convey the results to others, such as superiors or prospective
investors. Today, very complex Monte Carlo models can be designed and executed by anyone
with access to a personal computer.

ARTICLE SOURCES

Related Articles
RISK MANAGEMENT
What Is the Parametric Method in Value at Risk (VaR)?

PORTFOLIO MANAGEMENT
Bet Smarter With the Monte Carlo Simulation

TOOLS FOR FUNDAMENTAL ANALYSIS

Using Common Stock Probability Distribution Methods

TOOLS FOR FUNDAMENTAL ANALYSIS

Learn How to Create a Monte Carlo Simulation Using Excel

FINANCIAL ANALYSIS
What Can The Monte Carlo Simulation Do For Your
Portfolio?
https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 6/8
12/29/2020 Using Monte Carlo Analysis to Estimate Risk

TRADING BASIC EDUCATION

Hypothesis Testing in Finance: Concept and Examples

Partner Links

Related Terms
Monte Carlo Simulation
Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot
easily be predicted. more

What Are the Odds? How Probability Distribution Works

A probability distribution is a statistical function that describes possible values and likelihoods that a
random variable can take within a given range. more

Multivariate Model
The multivariate model is a popular statistical tool that uses multiple variables to forecast possible
investment outcomes. more

How Risk Analysis Works

Risk analysis is the process of assessing the likelihood of an adverse event occurring within the corporate,
government, or environmental sector. more

Expected Value (EV)

The expected value is the anticipated value for a given investment at some point in the future. more

https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 7/8
12/29/2020 Using Monte Carlo Analysis to Estimate Risk

Runs Test
Traders use a runs test to determine the randomness of data by revealing any variables that might affect
data patterns, such as a stock's price movement. more

TRUSTe

About Us Terms of Use

Dictionary Editorial Policy

Advertise News

Privacy Policy Contact Us

Careers California Privacy Notice

Investopedia is part of the Dotdash publishing family.

https://www.investopedia.com/articles/financial-theory/08/monte-carlo-multivariate-model.asp 8/8