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Monte Carlo Simulation in R: Part 1


By Jonathan Regenstein @jkregenstein  from @rstudio


Today we start a series of posts on running and visualizing Monte Carlo portfolio simulations. This series is excerpted from my new book Reproducible Finance with R

Let’s get to it!

Monte Carlo relies on repeated, random sampling and we will sample based on two parameters: mean and standard deviation of portfolio returns.
 

+ SPY (S&P500 fund) weighted 25%
+ EFA (a non-US equities fund) weighted 25%
+ IJS (a small-cap value fund) weighted 20%
+ EEM (an emerging-mkts fund) weighted 20%
+ AGG (a bond fund) weighted 10%


Before we can simulate that portfolio, we need to calculate the historical portfolio monthly returns, which was covered in this article on Introduction to Portfolio Returns.

I won’t go through the logic again, but the code is here:
 

# These are the package we need for today's post.
library(tidyquant)
library(tidyverse)
library(timetk)
library(broom)

symbols <- c("SPY","EFA", "IJS", "EEM","AGG")

prices <- 
  getSymbols(symbols, src = 'yahoo', 
             from = "2012-12-31",
             to = "2017-12-31",
             auto.assign = TRUE, warnings = FALSE) %>% 
  map(~Ad(get(.))) %>%
  reduce(merge) %>% 
  `colnames<-`(symbols)

w <- c(0.25, 0.25, 0.20, 0.20, 0.10)

asset_returns_long <-  
  prices %>% 
  to.monthly(indexAt = "lastof", OHLC = FALSE) %>% 
  tk_tbl(preserve_index = TRUE, rename_index = "date") %>%
  gather(asset, returns, -date) %>% 
  group_by(asset) %>%  
  mutate(returns = (log(returns) - log(lag(returns)))) %>% 
  na.omit()

portfolio_returns_tq_rebalanced_monthly <- 
  asset_returns_long %>%
  tq_portfolio(assets_col  = asset, 
               returns_col = returns,
               weights     = w,
               col_rename  = "returns",
               rebalance_on = "months")


We will be working with the data object portfolio_returns_tq_rebalanced_monthly and we first find the mean and standard deviation of returns.

We will name those variables mean_port_return and stddev_port_return.

mean_port_return <- 
  mean(portfolio_returns_tq_rebalanced_monthly$returns)

stddev_port_return <- 
  sd(portfolio_returns_tq_rebalanced_monthly$returns)


Then we use the rnorm() function to sample from a distribution with mean equal to mean_port_return and standard deviation equal to stddev_port_return. That is the crucial random sampling that underpins this exercise.

We also must decide how many draws to pull from this distribution, meaning how many monthly returns we will simulate. 120 months is 10 years and that feels like a good amount of time.

simulated_monthly_returns <- rnorm(120, 
                                   mean_port_return, 
                                   stddev_port_return)

Have a quick look at the simulated monthly returns.

head(simulated_monthly_returns)
[1]  0.050944351 -0.017579195  0.008322081  0.007901221  0.016835474
[6] -0.028979050
tail(simulated_monthly_returns)
[1] -0.010568223 -0.033228157 -0.012189181 -0.002823064  0.040136745
[6] -0.001618285

Next, we calculate how a dollar would have grown given those random monthly returns. We first add a 1 to each of our monthly returns, because we start with $1.

simulated_returns_add_1 <- 
  tibble(c(1, 1 + simulated_monthly_returns)) %>% 
  `colnames<-`("returns")

head(simulated_returns_add_1)
# A tibble: 6 x 1
  returns
    
1   1.00 
2   1.05 
3   0.982
4   1.01 
5   1.01 
6   1.02 


That data is now ready to be converted into the cumulative growth of a dollar. We can use either accumulate() from purrr or cumprod(). Let’s use both of them with mutate() and confirm consistent, reasonable results.

simulated_growth <- 
simulated_returns_add_1 %>%
    mutate(growth1 = accumulate(returns, function(x, y) x * y),
           growth2 = accumulate(returns, `*`),
           growth3 = cumprod(returns)) %>% 
    select(-returns)

tail(simulated_growth)
# A tibble: 6 x 3
  growth1 growth2 growth3
          
1    2.70    2.70    2.70
2    2.61    2.61    2.61
3    2.58    2.58    2.58
4    2.57    2.57    2.57
5    2.68    2.68    2.68
6    2.67    2.67    2.67

 

We just ran 3 simulations of dollar growth over 120 months. We passed in the same monthly returns and that’s why we got 3 equivalent results.

Are they reasonable? What compound annual growth rate (CAGR) is implied by this simulation?

cagr <- 
  ((simulated_growth$growth1[nrow(simulated_growth)]^
      (1/10)) - 1) * 100

cagr <- round(cagr, 2)


This simulation implies an annual compounded growth of 10.32%. That seems reasonable given our actual returns have all been taken from a raging bull market. Remember, the above code is a simulation based on sampling from a normal distribution. If you re-run this code on your own, you will get a different result.

If we feel good about this first simulation, we can run several more to get a sense for how they are distributed. Before we do that, let’s create several different functions that could run the same simulation.

Several Simulation Functions

Let’s build 3 simulation functions that incorporate the accumulate() and cumprod() workflows above. We have confirmed they give consistent results so it’s a matter of stylistic preference as to which one is chosen in the end. Perhaps you feel that one is more flexible or extensible or fits better with your team’s code flows.

Each of the below functions needs 4 arguments: N for the number of months to simulate (we chose 120 above), init_value for the starting value (we used $1 above) and the mean-standard deviation pair to create draws from a normal distribution. We choose N and init_value, and derive the mean-standard deviation pair from our portfolio monthly returns.

Here is our first growth simulation function using accumulate().

simulation_accum_1 <- function(init_value, N, mean, stdev) {
    tibble(c(init_value, 1 + rnorm(N, mean, stdev))) %>% 
    `colnames<-`("returns") %>%
    mutate(growth = 
             accumulate(returns, 
                        function(x, y) x * y)) %>% 
    select(growth)
}

Almost identical, here is the second simulation function using accumulate().

simulation_accum_2 <- function(init_value, N, mean, stdev) {
  tibble(c(init_value, 1 + rnorm(N, mean, stdev))) %>% 
    `colnames<-`("returns") %>%
  mutate(growth = accumulate(returns, `*`)) %>% 
  select(growth)
}

Finally, here is a simulation function using cumprod().

simulation_cumprod <- function(init_value, N, mean, stdev) {
  tibble(c(init_value, 1 + rnorm(N, mean, stdev))) %>% 
    `colnames<-`("returns") %>%
  mutate(growth = cumprod(returns)) %>% 
  select(growth)
}


Here is a function that uses all three methods, in case we want a fast way to re-confirm consistency.

simulation_confirm_all <- function(init_value, N, mean, stdev) {
  tibble(c(init_value, 1 + rnorm(N, mean, stdev))) %>% 
    `colnames<-`("returns") %>%
    mutate(growth1 = accumulate(returns, function(x, y) x * y),
           growth2 = accumulate(returns, `*`),
           growth3 = cumprod(returns)) %>% 
    select(-returns)
}

Let’s test that confirm_all() function with an init_value of 1, N of 120, and our parameters.

simulation_confirm_all_test <- 
  simulation_confirm_all(1, 120, 
                         mean_port_return, stddev_port_return)

tail(simulation_confirm_all_test)
# A tibble: 6 x 3
  growth1 growth2 growth3
          
1    2.93    2.93    2.93
2    2.89    2.89    2.89
3    3.01    3.01    3.01
4    3.18    3.18    3.18
5    3.21    3.21    3.21
6    3.31    3.31    3.31

 

We’re ready to visualize!

That’s all for today. Next time we will explore methods for running more than one simulation with the above functions and then charting the results.

 

 

 

Written by Jonathan Regenstein, Director of Financial Services, RStudio. His book "Reproducible Finance with R: Code Flows and Shiny Apps for Portfolio Analysis" is available on CRC and Amazon.

RStudio offers Open source and enterprise-ready professional software for R. Learn more here: https://www.rstudio.com/

This article is written by Jonathan Regenstein, Director of Financial Services, RStudio, and is being posted with his permission. The views expressed in this article are solely those of the author and IB is not endorsing or recommending any investment or trading discussed in the article. This material is for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IB to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Any trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations. Past performance is not necessarily indicative of future results.


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