Let’s define first what risk is. With risk we usually mean the chance that something undesirable will occur, which we then try to avoid or minimize. But risk can also mean a chance that something desirable will happen. In either case, the more uncertainty exists about the potential outcome the riskier we perceive it. Hence, to reduce this uncertainty and risk we should increase our knowledge about the uncertain events.

What are the sources of uncertainty? In business situations uncertainty arises in many ways. Demand for company’s products for example is uncertain since it depends on many economic factors and sometimes unknown customer preferences. Optimal prices to charge for company’s products or services may be uncertain since they are driven by unknown customer expectations and competitors’ pricing. And even operating expenses may be uncertain when it comes to forecasting required investments needed to bring a product to market.

Some of these uncertainties are outside of company’s control. Weather, for example, is an uncertainty that cannot be controlled and if you are selling umbrellas this uncertainty will impact your sales. But you can at least prepare yourself by analyzing potential weather scenarios and ordering the number of umbrellas that will maximize your profit. Other uncertainties, on the other hand, can be reduced by company’s actions. For example the uncertainty about optimal product pricing can be reduced through market research and pricing analysis helping to narrow down on only few desirable price points.

Most businesses need to make decisions in light of these uncertainties by taking calculated risk. Risk analysis provides the means to make this calculation. Risk analysis is nothing more than the analysis of potential uncertainties that may have an impact on the business. This scenario analysis can help to quantify the potential risks.

Scenario analysis in its basic form identifies few potential cases of what could happen. In this basic form, however, usually only few scenarios can be evaluated although in reality there are many uncertainties that need to be analyzed at once. Here is where Monte Carlo simulation can help.

Monte Carlo simulation is a sophisticated scenario analysis that can evaluate thousands of scenarios at once. Businesses can then better understand the uncertainties they encounter. You can find more about Monte Carlo simulation either in one of our previous posts or in our Monte Carlo simulation tutorial. Needless to say, Monte Carlo simulation is embedded in some of FinanceIsland’s tools to help identify for example potential outcomes of return on investment or company’s cash flows. This allows every company to perform risk analysis.

Monte Carlo simulation is a sophisticated scenario analysis. It’s a technique where you can model thousands of scenarios in a matter of seconds. Unlike typical scenario or what-if analyses that allow you to analyze the impact of changing one input variable at a time, Monte Carlo simulation analyzes all possible combinations at once. In a typical scenario analysis, you manually calculate as many scenarios as you deem necessary. Monte Carlo simulation, on the other hand, calculates these scenarios automatically, based on your definition of simulation parameters. It allows you to run thousands of scenarios instead of the few in a typical what-if analysis.

Monte Carlo simulation was popularized by physicists in the 1950s at the dawn of the computer age and it got its name from the Monte Carlo Casino in Monaco. Games of chance played at a casino exhibit random behavior that is bound by the characteristics of the game. When rolling a die for example, you know that a number between 1 and 6 will come up, but you don’t know which one.

Similarly, in an investment project you may know the range of possible financial outcomes, but you don’t know exactly which one will materialize. Monte Carlo simulation allows you to model all potential scenarios driven by the uncertain inputs. As a result you will know not just whether an investment will be profitable, but how likely it is to be profitable and how profitable it is likely to be.

Although Monte Carlo simulation will not eliminate uncertainties in business decisions, it can help you to understand them in normal business circumstances. For example, if there is a chance of negative financial outcome in your business, Monte Carlo simulation allows you to assess what might go wrong and helps you to be proactive with the decisions you make. Similarly, if you’re allocating resources among several projects, Monte Carlo simulation helps you to determine which ones have the greatest chance of success.

Monte Carlo simulation can especially be helpful in financial projections for investments that are not based on repeated past experiences. These projections are most often badly flawed. Although Monte Carlo simulation will not help to predict all possible events, it will help to prepare for those events.

Monte Carlo simulation can only go so far, however. It is, like also standard scenario analyses, only accurate for scenarios not wildly different than typical business circumstances. There may be, however, extraordinary, though not absolutely unlikely events that are widely different. Events like these, referred to also as Black Swans, have a low likelihood of occurrence, but big impact. Since Black Swans are unexpected by definition, they are not modeled in financial analyses. But more on Black Swans at some other point in time.