This article from IndexUniverse.com details just one of the ways Monte Carlo simulation can be tuned to the combined unfolding of time and risk. First, a little background.
Since Harry Markowitz won the Nobel Prize in Economics in 1990, the Efficient Frontier has been the line in the sand under which portfolio managers wiggle their toes. The Efficient Frontier is a major component of his Modern Portfolio Theory, which brought him the big prize. In the 1950s Markowitz was researching the idea of the present value of investments in order to optimize the return across collection or portfolio of these, and he realized that the element that was missing from ideas about present value was risk. This insight led, eventually, to his prescriptions for diversifying investments to maximize the return and minimize the risk across an entire portfolio.
Portfolio diversification is now gospel among financial planners. But gospel doesn’t mean all investment advisors treat or even produce the same Monte Carlo Excel models of portfolio risk in the same way. We’ll look at one approach in Part II.