What Is the Monte Carlo Simulation, and How Can It Help You

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What Is the Monte Carlo Simulation, and How Can
It Help You
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• What is Monte Carlo simulation? In short, it is a
  way to represent and analyze risk and
  uncertainty. It was named after the Monte Carlo
  Casino which opened in 1863 in the Principality
  of Monaco on the French Riviera. The Monte Carlo
  simulation generates random numbers using a
  pseudo-random number algorithm. The uncertainty
  in key input quantities is represented as a
  probability distribution.

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• In standard Monte Carlo simulation, a software
  program samples a random value from each input
  distribution and runs the model using those
  values. After repeating the process a number of
  times, usually 100-10,00, it estimates the
  probability distributions of uncertain outputs of
  the model from the random sample of output
  values. The larger the sample size, the more
  accurate the estimation of the output
  distributions.

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• A common misconception is that computational
  effort is combinatorial in the number of
  uncertain inputs - making it impractical for
  large models. This is true for simple discrete
  probability tree methods, but the great advantage
  of this method is that the computation is linear
  in the number of uncertain inputs. It is
  proportional to the number of input distributions
  to be sampled.

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• The sample size you need is controlled by the
  degree of precision that you want in the output
  distributions you care about. For example, you
  are interested in estimating percentiles of a
  cumulative distribution. There is no need to
  increase the sample size just because you have
  more uncertain inputs. For most models, a few
  hundred up to a thousand runs are sufficient. You
  only need a larger sample if you want high
  precision in your resulting distributions and a
  smooth looking density function. Given the
  inherent uncertainty of the inputs, higher
  precision is usually an aesthetic preference
  rather than a functional need.

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• Microsoft Excel and other spreadsheets do not
  support Monte Carlo simulation directly. But
  there are a number of software products that are
  add-ins to Excel that let you perform the
  simulation. There are products that are well
  known to do this, but what sets Analytica apart?
  We have designed Analytica specifically to
  perform Monte Carlo simulations so the
  probabilistic analysis is fully integrated into
  the product from the start. This gives Analytica
  certain advantages over spreadsheet add-ins in
  terms of ease of use and speed of computation.
  For more information about Analytica visit
  www.analytica.com or call 650-212-1212.