From time to time I like to put on my geek hat and do some charts and graphs. This weekend was one of those Monte Carlo weekends.

You've probably seen those pretty Monte Carlo charts the financial planning sites are so fond of. You know the ones. You input the value of your retirement savings today and your risk tolerance. You tell it how old you are, how long you think you'll live and when you'd like to retire. Then you give it an estimate of your retirement expenses. When you click the submit button they show you a graph of how your portfolio will perform in the future.

Well, not exactly how it will perform. The charts I've seen usually have a bunch of lines, each roughly progressing up and to the right, but with fluctuating returns. You probably know the ones I'm talking about. If you don't, you're about to see some examples which will get you familiar with them.

I spent a little time this weekend investigating for myself how those charts are produced so that I could project for myself what my own retirement might look like. The technique commonly used to create them is a process known as Monte Carlo simulation. Monte Carlo simulation is an iterative mathematical technique to simulate the effects of randomly distributed inputs to a process. In the case of my own portfolio analysis, the random inputs are the yearly returns from a given investment.

The following three charts plot possible returns from the same $10,000 investment returning the same 10%. The difference is the amount of risk, or volatility inherent in each investment.

As you can see by comparing these charts the amount of risk, or volatility, in an investment as described by the Standard Deviation of returns has a profound effect on the overall return of the investment.

Volatility is an important factor in selecting investment vehicles. Monte Carlo simulation is a valuable tool which I think I'll spend more time to learn. I think it could come in very handy in choosing how to invest that next retirement dollar.