Everything that we do consists of one or other levels of risk. In every process, and planning, we face uncertainty, ambivalence, and variability. This ambiguity and variability can be mostly found in business processes. No one can foresee the future, but a new method has come up in the market that can help you identify all the possible results of your decisions. Yes, the process of prediction is known as Monte Carlo Simulation. This process helps you to determine the outcome that you may get because of your decision and also helps you in effective decision making.
Table of Contents
What is Monte Carlo Simulation?
Monte Carlo Simulation is a digital form of mathematical technique and formula that helps people to know about the risk involved in all kinds of decision making and analysis. Thus, it allows people to predict the result or helps them to expect the desired result by risk analysis.
The technique of Monte Carlo Simulations is used in almost all kinds of industries and sectors. Some of the major industries that use Monte Carlo Simulation include finance, project management, energy, manufacturing, R&D, engineering, oil and gas, and any other production you can think of. The process helps leaders and business people with complete analysis and helps them predict what can happen.
The process provides more in-depth insights and furnishes decision-makers and industry leaders with a wide range of possible outcomes. The outcome can include best as well as worst results. Thus, having this mathematical technique at the bay can help users to gauge the effectiveness of the decision they are going to make.
The technique of Monte Carlo was used by a scientist who was first operating on the atom bomb project during World War II. It was named after the town Monte Carlo that is famous for its casinos. Since the introduction of the Monte Carlo technique in World War II, it has been used in numerous physical as well as conceptual systems and processes.
Why do you need a Monte Carlo Simulation (MCS)?
Every business or industry needs MCS because of uncertainty in forecasting models. When a forecasting model is developed, it needs an assumption. The assumption can be anything related to the project. For example, it can be about the expected return on investment, and it can be about the time to be taken for completion of a project, or even about the probability of gain or loss. Since we cannot predict all these scenarios, thus people estimate an expected value.
Since you can’t estimate an exact value or result, it contains some inherent risk, and this is because nothing is guaranteed. Thus, people use a mathematical model called MCS, which can give an almost predicted result.
What can Monte Carlo Simulation tell you?
If you have a range of possible values, for example, if you have precise data about how much time a construction project will continue, you may have a minimum amount as well as a maximum value. Thus, range value can help you to understand the risk and uncertainty in a project. Therefore, the primary function of the MCS is to tell you based on range values, how likely the outcomes are. Thus, you may have an almost clear understanding of the result and consequences of your project.
How does the Monte Carlo Method work?
The basic functionality of the MCS is to perform risk analysis. The MCS is used to build different models of possible results. The process substitutes different ranges hundreds of times. It uses different values each time to get different sets of results. An MCS performs analysis and calculates the result of hundreds and thousands of times before giving the final result. An MCS process uses different probability distributions to describe different uncertainty and risks.
Some of the joint probability distribution includes:
Normal:
It is a bell-shaped probability distribution. Also, it is symmetric and mostly used to describe different natural phenomenons like height. It is also used to get an analysis of some variables like energy prices and the rate of inflation.
Lognormal:
The values are positively misrepresented and are not symmetrical as a standard curve in this probability distribution. It is mostly used to analyze and show benefits that don’t move below zero. You can represent some data through Lognormal includes property value, the value of shares, and stock of oil.
Uniform:
In this case, all values have an equal probability of occurrence. Examples of variables that are uniformly distributed include future sales revenue.
Triangular:
Under this, the user describes the minimum, most probable, and the maximum value. Under this, the amount around the most likely has a higher chance of occurrence. The best example of a variable is the triangular distribution which includes past sales history.
PERT:
Under this distribution, the user defines the minimum, most likely, and the maximum value, just like in a triangular distribution. But the only difference is that in case the values between the most likely and the extremes have more probability of occurrence. It is mostly used for project management models.
Under the MCS, the values are taken at random from the probability distribution mentioned above. Each set of samples taken from the distribution is called the Iteration. After the samples are made, the results from the samples are recorded. This process is repeated hundreds and thousands of times. Thus the MCS process provides results more comprehensively. It will tell you not only about what would happen but also about how likely it can happen.
What are the advantages of a Monte Carlo technique?
- The most significant advantage of the MCS technique is that it not only informs what is most likely to happen but also shows how likely each outcome can happen.
- Because of the data generated by MCS, it is straightforward to create graphs related to different outcomes. Thus, the figures enable the stakeholders to communicate and understand in a better way, which is not possible with primary numeric data.
- Under the MCS technique, it becomes straightforward for the stakeholders to see which input had the most significant result or outcome on the bottom-line results.
- Under the MCS approach, analysts can also see which inputs had higher values together. Thus, it can also be used to pursue further analysis.
- Analysts can also predict and look at the independent as well as co-dependent variables. Thus, they can quickly determine what the effect of one variable over another is. For example, when a variable goes up, it can lead to the other variable to go down. Thus, this inverse relationship can be beneficial for stakeholders to determine the future course of action.
- Time compression is possible in case of MCS
- The technique and the process of MCS is pretty straightforward and flexible
- Real-world complications can also be included in case of MCS analysis
- The method also includes “what if” type of questions.
- The process does not interfere with real-world systems.
Disadvantages of Monte Carlo Simulation:
Following are some of the significant drawbacks of MCS:
- The process can take longer durations to develop, and it can often be costly for smaller firms.
- MCS is a kind of trial and error approach. It is because it produces different results in different scenarios.
- Each model and result are different.
- The result of MCS is only the approximate value, and they don’t give you real value.
- The process is cumbersome and time-consuming. It is because you have to generate a large number of samples to get almost an approximate result.
Some of the primary applications of the Monte Carlo Method:
Some of the primary forms of simulations include the following:
- Scheduling of bus
- Library operations designing
- Location and dispatching of ambulance
- Scheduling of aircrafts
- Decisions of hiring labors
- Scheme of Traffic light timing
- Prediction of voting pattern
- Scheduling of production facility
- Capital investments
- Programming of different kinds of productions
- Inventory planning
- The layout of different plants and industries
- Construction projects
- Designing of a parking lot
- Taxi and truck dispatching
How reliable is MCS?
Just like any other forecasting process, MCS has its own merits and demerits. It can only give you better results if you estimate well. Thus, the result depends upon the type and kind of prediction you make.
For all kinds of analysts, it is essential to understand that simulation is a kind of prediction, and it can’t guarantee you an actual result. Nevertheless, the simulation technique can be used as an essential tool.
Other benefits of Monte Carlo Simulation:
The simulation has one of the best uses that includes; it helps people to predict and prepare the analysis of any given scenario. It also assures people that they are spending their time and energy on something that will provide them with a particular result.
For example, if a real-estate owner believes and knows about a particular level of profit or loss he/she may incur, he will work towards a guaranteed result. Thus, prediction through MCS always helps the business as well as other industry leaders and people.
It can also be used to support and validate that resources are used in a proper direction. For example, if investors are assured that the funds they are investing will give them almost guaranteed results, more investors will invest. Thus, simulation helps the business as well as investors in the decision-making process.
It can also be used to validate the commercial as well as the technological viability of specific projects. Thus, if an entrepreneur is not sure whether the project he/she is pursuing is viable or not, he/she can use MCS to get a guaranteed result.
The MCS model helps you to make changes in the plan, your business process, as well as fund and labor allocation. This certainty is possible because, with MCS, you can get an almost guaranteed prediction. It also helps you to distinguish between different types of risks.
Specific points that need to be kept in mind when using MCS:
Some of the points that must be kept in mind when using MCS include:
- Try to be vigilant at every step in the process
- Be vigilant against overconfidence. Overconfidence towards a particular result can often hamper your achievement. Thus it is good to be unsure sometimes.
- Specific risks and events are always outside human control, and even MCS won’t cover those risks. Thus, bear in mind all these kinds of risks.
Using exercises and techniques like MCS can help influence a lot about how you think and how you make your decisions. It not only helps in making decisions, but it also helps in viewing your past choices and analyzing your options. The model tries to simplify the complex world full of data, and sometimes it may or may not give the desired results.
Models like MCS may not be perfect, but it influences the decision making power and helps in analyzing different scenarios.
Final thoughts
It is often said that there is only one certainty in the world, and that is “there is no certainty.”
So, no matter if you believe in techniques and methods like MCS or not, it will improve your decision making and analysis capability. MCS is one of the best ways of weighing the possibility. We can’t predict anything in the world, not even MCS results. But it can gauge the results of the future.
It can be used to quickly know about the probability of what may or may not happen in the future. Despite certainty and uncertainty, we have to act, and we must decide. Thus, try to work on your judgment and use MCS when you think you need to make a risk analysis.
So, if you are facing uncertainty, variability, and ambiguity in any situation of prediction, and you want to get an accurate result, try to use the MCS model. This model will give you precise, almost results, and projections.
