Apartment Investing – Monte Carlo Style!
Monte Carlo is known as “an international byword for the extravagant display and reckless dispersal of wealth” thanks to the world famous Place du Casino. People that have the privilege of ‘recklessly dispersing’ their wealth at the casino have no problem gambling large amounts of money. Their level of wealth affords them the luxury of easily taking the risk of losing money since the loss is of little consequence for their extreme wealth.
The French Riviera. Ahhh… how nice that must be, even just to visit Monte Carlo and the south of France. Thoughts of James Bond run through my mind and his collection of winnings from what seemed to be effortless gambling at very high stakes. For 99% of the rest of us, gambling may be fun but we have our practical limits and may not be so lucky. My few trips to Las Vegas had a specific (gambling) budget and the anticipation that the money would all be lost – the cost of being entertained. I had no expectation that I would walk away with more money than I went with.
No one wants to gamble with an investment, especially if that investment is intended to support us in retirement or help pay for college, etc. These investments are very serious and in no way do we want to consider them gambling. On the contrary, we are very careful with investments to the extent that we may choose not to invest in something that we simply don’t feel comfortable with, even with predictions of big returns.
Most of the time, that discomfort comes from a lack of confidence in the outcome of the investment. For example, what happens to my investment if inflation is different from the prediction or the forecast earnings are not met? If only we had a true crystal ball that could tell us what these future numbers will be, we could easily calculate the result. Our investment decisions could then be made with much higher confidence.
The normal way to predict the outcome of an investment is to put together a formula that includes many variables that define the result. While these variables are data that can ‘vary’ depending on many unknown future events, we must select a single number for each variable to enter into our formula. An example is the variable of income. In a business, we typically use historic data (like the last 3 months of income) to help predict what future performance will be, but we know that it could easily and likely be different from the number we choose. This method of calculating with specific numbers is called deterministic, meaning that the result will give us a single number result. Adjusting variables requires calculating many times, resulting in many different numbers. The problem is, which number should we put our money on?
Another method to calculate an outcome is called probabilistic. Instead of using fixed numbers to calculate one number result, this method allows the variables to naturally ‘vary’ based on their historic probability. For example, we may use historic data as our expected value for income, but it naturally could be a lower number or a higher number. We can set boundaries on the low and high numbers based on their likelihood with a certain level of confidence, i.e. lowest probable number and highest probable number. Now, instead of picking a single number to use in our calculation, we can use a range of numbers that are most probable, giving us more confidence that we have covered the range of possibilities.
The result of this probabilistic calculation is a probability distribution of results (think normal distribution curve from your statistics class). This tells us the probability of any outcome we are interested in. For example, if we want a 10% return on our investment, we simply look at the results and find out what the probability of getting that 10% return. From the same resulting curve, we can determine the probability of any return (5%, 10%, 15%, etc.). With this information, we now have a way to predict results with a higher level of confidence.
Monte Carlo is also the name of a common probabilistic method. The name was chosen by scientists working in secrecy on nuclear experiments in the 1940s. The Monte Carlo Method is a broad class of computational algorithms that rely on repeated random sampling to obtain numerical results. Sounds complicated, and it is – requiring lots of computer power, but the results have great value when making important investment decisions. The difference is a qualified statement (“your returns could be 10%”) vs a quantified statement (“there is a 60% chance that your returns will be 10%”).
I use the Monte Carlo method to calculate returns of apartment investments. The results allow me to select investments based on quantified predictability. My engineering training has taught me to use every tool at my disposal and this is one of the most powerful ones. With it, I’m able to execute with more certainty and invest in apartments – Monte Carlo style!
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Do some of your investments feel like a gamble?
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