This Tool Will Tell Your Financial Future

If you could tell the future, then all your financial problems would be history. You could have invested in all the top stocks at their IPOs, held them throughout their heydays, and bailed out before some of them fell back to earth. Picking stocks would be a snap.

At least so far, I haven't discovered the secret of forecasting the future with absolute certainty. But there is a method that financial planners use to make some educated guesses about the future -- and to tell you what you need to do in order to save enough to meet all your financial needs.

Telling the future
In this month's brand-new issue of the Fool's Rule Your Retirement newsletter -- which is available this afternoon at 4 pm ET -- Foolish retirement expert Robert Brokamp takes a close look at the planning tool known as Monte Carlo analysis. Using Monte Carlo can help you make more precise estimates of the most likely outcomes of a given investing plan, allowing you to choose the plan that best fits your ability to save, your tolerance for investment risk, and your lifestyle.

Without Monte Carlo, portfolio analysis relies almost entirely on what assumptions you make about future returns. You can look at your asset allocation and determine average historical returns for each asset class that you own. Using those return assumptions, you can calculate how much money you should expect to have at any point along an appropriate time frame.

The problem, though, is that if your actual return proves lower, then you may get blindsided, forcing you to boost your savings to catch up. Ideally, it'd be best to avoid those surprises and cover all contingencies at the outset.

The value of Monte Carlo
Monte Carlo analysis steps in where simple portfolio analysis leaves off. Rather than looking at a single outcome, Monte Carlo uses software to run through hundreds of possible future scenarios. That way, you know not only the most likely outcomes but also how big a potential problem you may have if things turn out worse than you expected.

For instance, let's look closely at 2008, which was obviously a horrible year for the financial markets:

Source: Morningstar. 2008 returns come from index-tracking ETFs in some instances.

Too often, financial plans gloss over the impact that years like 2008 can have on a portfolio -- especially for those near or in retirement. Monte Carlo analysis does a better job of taking those years into account. So, even though they won't necessarily happen in every 20- or 30-year period, they'll show up in some of the Monte Carlo projections. That will warn you of potential trouble and let you take steps to handle that risk up front.

Solving the problem
In the end, what you're left with is a range of possible returns and scenarios, which you can then compare with your capacity to save and invest over time. That will tell you how likely it is that you'll save enough to make your money last as long as you're likely to need it -- and give you advance warning if you're not saving enough to handle unforeseen problems.

As complicated as all of this sounds, this month's Rule Your Retirement gives you all the help you need to understand and use Monte Carlo analysis. To learn more, you'll want to check out this month's feature article, as well as the model portfolios that Robert recommends for investors at various stages in their lives. And if you're not a Rule Your Retirement subscriber, don't let that stop you -- click here for a 30-day free trial that will give you full access to this and everything else we have to offer.

When it comes to your retirement, you need all the tools you can get. With the help of Monte Carlo analysis, you'll have a better map toward a successful retirement.

For more on avoiding big retirement mistakes:

• You'll never retire at this rate.
• Four ways you could destroy your retirement.
• Some tricks for helping your portfolio recover.