Was studying Reading 16 of SS4 and came across this portion on Monte Carlo Simulation for core and excess capital (page 280 of Schweser Notes Book 1). I don’t really understand what this section is trying to say and what are the key takeaways, it seems to contain a lot of information but does not say how core capital and excess capital is determined using Monte Carlo. Anyone can explain? Thanks!
Let’s make some basic terminology right: You have some wealth and you want to determine how much of it is needed to support your lifestyle for the rest of your life. That part is called core capital, and is for you to consume. The rest: Total wealth - core capital = excess wealth --> can be given away either right away or later depending on your tax situation --> the planning process of giving away this excess wealth is called estate planning to optimize/minimize the tax to be paid. To determine this core capital, there are many tools. CFAI text mentions at least three of them: mortality table, ruin probability and Monte Carlo. It also boils down to determine how much is needed so that you don’t outspend your core capital, given your likely lifespan, your planned lifestyle, portfolio return. Which tool to use is a trade off between resource and simplicity. Monte Carlo is the most advanced, flexible of all, but requires much more input. The process of running Monte Carlo could be summarized as followed: • Run simulation and find core capital enough in at least 95% of trials, using different portfolio returns based on some assumed distribution. • Add reserve: smaller than in mortality case since Monte Carlos has already captured the risk of producing a sequence of anomalously poor returns. You need to check the LOS this year to see what you need to master in this reading concerning the Monte Carlo, but I believe (but I am not sure) you need, at least, to contrast the strength and weakness of Monte Carlo method with the other tools.