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com

Monte Carlo simulation, or probability simulation, is a technique used to understand the impact of risk

and uncertainty in financial, project management, cost, and other forecasting models.

When you develop a forecasting model – any model that plans ahead for the future – you make certain

assumptions. These might be assumptions about the investment return on a portfolio, the cost of a

construction project, or how long it will take to complete a certain task. Because these are projections

into the future, the best you can do is estimate the expected value.

You can't know with certainty what the actual value will be, but based on historical data, or expertise in

the field, or past experience, you can draw an estimate. While this estimate is useful for developing a

model, it contains some inherent uncertainty and risk, because it's an estimate of an unknown value.

In some cases, it's possible to estimate a range of values. In a construction project, you might estimate

the time it will take to complete a particular job; based on some expert knowledge, you can also

estimate the absolute maximum time it might take, in the worst possible case, and the absolute

minimum time, in the best possible case. The same could be done for project costs. In a financial

market, you might know the distribution of possible values through the mean and standard deviation of

returns.

By using a range of possible values, instead of a single guess, you can create a more realistic picture of

what might happen in the future. When a model is based on ranges of estimates, the output of the

model will also be a range.

This is different from a normal forecasting model, in which you start with some fixed estimates – say

the time it will take to complete each of three parts of a project – and end up with another value – the

total time for the project. If the same model were based on ranges of estimates for each of the three

parts of the project, the result would be a range of times it might take to complete the project. When

each part has a minimum and maximum estimate, we can use those values to estimate the total

minimum and maximum time for the project.

When you have a range of values as a result, you are beginning to understand the risk and uncertainty

in the model. The key feature of a Monte Carlo simulation is that it can tell you – based on how you

create the ranges of estimates – how likely the resulting outcomes are.

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What is Monte Carlo Simulation? www.riskamp.com

How It Works

In a Monte Carlo simulation, a random value is selected for each of the tasks, based on the range of

estimates. The model is calculated based on this random value. The result of the model is recorded,

and the process is repeated. A typical Monte Carlo simulation calculates the model hundreds or

thousands of times, each time using different randomly-selected values.

When the simulation is complete, we have a large number of results from the model, each based on

random input values. These results are used to describe the likelihood, or probability, of reaching

various results in the model.

For Example

For example, consider the model described above: we are estimating the total time it will take to

complete a particular project. In this case, it's a construction project, with three parts. The parts have

to be done one after the other, so the total time for the project will be the sum of the three parts. All the

times are in months.

Job 1 5 Months

Job 2 4 Months

Job 3 5 Months

Total 14 Months

Table 1: Basic Forecasting Model

In the simplest case, we create a single estimate for each of the three parts of the project. This model

gives us a result for the total time: 14 months. But this value is based on three estimates, each of which

is an unknown value. It might be a good estimate, but this model can't tell us anything about risk.

How likely is it that the project will be completed on time?

To create a model we can use in a Monte Carlo simulation, we create three estimates for each part of

the project. For each task, we estimate the minimum and maximum expected time (based on our

experience, or expertise, or historical information). We use these with the “most likely” estimate, the

one that we used above:

Job 1 4 Months 5 Months 7 Months

Job 2 3 Months 4 Months 6 Months

Job 3 4 Months 5 Months 6 Months

Total 11 Months 14 Months 19 Months

Table 2: Forecasting Model Using Range Estimates

Page 2 of 4

What is Monte Carlo Simulation? www.riskamp.com

This model contains a bit more information. Now there is a range of possible outcomes. The project

might be completed in as little as 11 months, or as long as 19 months.

In the Monte Carlo simulation, we will randomly generate values for each of the tasks, then calculate

the total time to completion1. The simulation will be run 500 times. Based on the results of the

simulation, we will be able to describe some of the characteristics of the risk in the model.

To test the likelihood of a particular result, we count how many times the model returned that result in

the simulation. In this case, we want to know how many times the result was less than or equal to a

particular number of months.

12 Months 1 0%

13 Months 31 6%

14 Months 171 34%

15 Months 394 79%

16 Months 482 96%

17 Months 499 100%

18 Months 500 100%

Table 3: Results of a Monte Carlo Simulation

The original estimate for the “most likely”, or expected case, was 14 months. From the Monte Carlo

simulation, however, we can see that out of 500 trials using random values, the total time was 14

months or less in only 34% of the cases.

Put another way, in the simulation there is only a 34% chance – about 1 out of 3 – that any individual

trial will result in a total time of 14 months or less. On the other hand, there is a 79% chance that the

project will be completed within 15 months. Further, the model demonstrates that it is extremely

unlikely, in the simulation, that we will ever fall at the absolute minimum or maximum total values.

This demonstrates the risk in the model. Based on this information, we might make different choices

when planning the project. In construction, for example, this information might have an impact on our

financing, insurance, permits, and hiring needs. Having more information about risk at the beginning

means we can make a better plan for going forward.

1 In this example, we use the beta-PERT distribution to generate random values based on a minimum, most likely, and

maximum value. The PERT distribution is often used to model estimates of expert data. For more information on this

and other probability distributions, see the documentation on our website.

Page 3 of 4

What is Monte Carlo Simulation? www.riskamp.com

11.5

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0% 20% 40% 60% 80% 100%

Like any forecasting model, the simulation will only be as good as the estimates you make. It's

important to remember that the simulation only represents probabilities and not certainty.

Nevertheless, Monte Carlo simulation can be a valuable tool when forecasting an unknown future.

________________________________________

About RiskAMP

RiskAMP is a Monte Carlo simulation engine that works with Microsoft Excel®. The RiskAMP Add-

in adds comprehensive probability simulation to spreadsheet models and Excel® applications. The

Add-in includes 22 random distributions, 17 statistical analysis functions, a wizard for creating charts

and graphs, and VBA® support – all for a fraction of the price of competing packages.

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