# Monte Carlo Simulation Basics

**Part 1**of "A Practical Guide to Monte Carlo Simulation",

*by Jon Wittwer, PhD*

[ Preface ] [ Sales Forecast Example ]

A **Monte Carlo method** is a technique that involves using random numbers and probability to solve problems. The term Monte Carlo Method was coined by S. Ulam and Nicholas Metropolis in reference to games of chance, a popular attraction in Monte Carlo, Monaco (Hoffman, 1998; Metropolis and Ulam, 1949).

**Computer simulation** has to do with using computer models to imitate real life or *make predictions*. When you create a model with a spreadsheet like Excel, you have a certain number of *input parameters* and a few equations that use those inputs to give you a set of *outputs* (or *response* variables).

This type of model is usually **deterministic**, meaning that you get the same results no matter how many times you re-calculate. [ **Example 1**: A **Deterministic Model** for Compound Interest ]

**Monte Carlo simulation** is a method for *iteratively* evaluating a deterministic model
using sets of random numbers as inputs. This method is often used when the model is
complex, nonlinear, or involves more than just a couple uncertain parameters.
A simulation can typically involve *over 10,000 evaluations* of the model, a
task which in the past was only practical using super computers.

**Example 2:** A Stochastic Model

By using **random inputs**, you are essentially turning the deterministic model into a stochastic model. Example 2 demonstrates this concept with a very simple problem.

In Example 2, we used simple *uniform random numbers* as the inputs to the model. However, a uniform distribution is not the only way to represent uncertainty. Before describing the steps of the general MC simulation in detail, a little word about *uncertainty propagation*:

The Monte Carlo method is just one of many methods for analyzing **uncertainty propagation**, where the goal is to determine how *random variation*, *lack of knowledge*, or *error* affects the *sensitivity*, *performance*, or *reliability* of the system that is being modeled.

Monte Carlo simulation is categorized as a **sampling method** because the inputs are randomly generated from *probability distributions* to simulate the process of sampling from an actual *population*. So, we try to choose a distribution for the inputs that most closely *matches data we already have*, or best represents our *current state of knowledge*. The data generated from the simulation can be represented as probability distributions (or histograms) or converted to *error bars*, *reliability predictions*, *tolerance zones*, and *confidence intervals*. (See Figure 2).

If you have made it this far, **congratulations**! Now for the fun part! The steps in Monte Carlo simulation corresponding to the uncertainty propagation shown in Figure 2 are fairly simple, and can be easily implemented in Excel for simple models. All we need to do is follow the **five simple steps** listed below:

**Step 1:**
**Create a parametric model**, y = *f*(x_{1}, x_{2}, ..., x_{q}).

**Step 2:**
**Generate a set of random inputs**, x_{i1}, x_{i2}, ..., x_{iq}.

**Step 3:**
**Evaluate the model** and store the results as y_{i}.

**Step 4:**
**Repeat** steps 2 and 3 for *i* = 1 to *n*.

**Step 5:**
**Analyze the results** using histograms, summary statistics, confidence intervals, etc.

On to an example problem ...

[ Preface ] [ Sales Forecast Example ]

### REFERENCES:

- Hoffman, P., 1998,
*The Man Who Loved Only Numbers: The Story of Paul Erdos and the Search for Mathematical Truth*. New York: Hyperion, pp. 238-239. - Metropolis, N. and Ulam, S., 1949, "The Monte Carlo Method."
*J. Amer. Stat. Assoc.*44, 335-341. - Eric W. Weisstein. "Monte Carlo Method." From MathWorld--A Wolfram Web Resource.
- "Introductory Econometrics via Monte Carlo Simulation with Microsoft Excel." From http://www.wabash.edu/econometrics/home.htm
- Paul Coddington. "Monte Carlo Simulation for Statistical Physics." Northeast Parallel Architectures Center at Syracuse University
- Decisioneering.com. "What is Monte Carlo Simulation? Part of: Risk Analysis Overview - http://www.decisioneering.com/risk-analysis-start.html