Legends of the Monte Carlo Technique

A recent blog in Investment Week that mentioned the history of Monte Carlo simulation and its use in finance led me to take a harder look at what I thought I knew about how financial risk analysis was launched.

I had long believed that Monte Carlo simulation was developed by a team working at Los Alamos Scientific Laboratory during the 1940s.  The blog mentioned Stanislaw Ulam playing solitaire. Both turned out to be true.  Ulam was part of the team working on nuclear weapons at Los Alamos, and he prefaced his own account of his inspiration from solitaire by saying,"After spending a lot of time trying to estimate them by pure combinatorial calculations, I wondered whether a more practical method than "abstract thinking" might not be to lay it out say one hundred times and simply observe and count the number of successful plays. This was already possible to envisage with the beginning of the new era of fast computers. . . ."  He and John von Neumann began to work on the calculations that eventually became essential to the Manhattan Project. 

So far, so true.  But how did Monte Carlo simulation enter the finance arena?  The blog fast forwards thirty years to 1976 and Roger G. Ibbotson and Rex A. Sinquefield with their publication of "Stocks, Bonds, Bill, and Inflation: Simulations of the Future."

True––but not so fast.  In the intervening years and especially during the 1950s, there was considerable development and dissemination of Monte Carlo simulation technique by the U.S. Air Force and the Rand Corporation.  This brought the technique closer to the realm of finance, but we’re not there yet.  

The earliest publication I can dig up on Monte Carlo and financial risk simulation is David B. Hertz’s "Risk Analysis in Capital Investment," published in the Harvard Business Review in 1964.

Harvard Biz
From Harvard Business Review, circa 1964

Okay, the 1960s.  That still leaves unattended by history almost fifty years, the advent of desktop computing, the commercialization of Monte Carlo software, acceleration through parallel computing, and the wafting up on the horizon of cloud computing.

So, in the words of too many finance journals, "more research is necessary."


Join the Conversation

1 Comment

  1. Hi Holly

    An interesting piece – it made me recall the first instance in my education when I came across the Monte Carlo technique. It was work done by Louis Pouliquen in:

    Pouliquen, L.Y., 1970, Risk Analysis in Project Appraisal, World Bank Staff Occasional Papers
    No. 11, Johns Hopkins Press, Baltimore.

    The paper showed how risk appraisal techniques could be used in appraising projects, and used three case studies to illustrate the point. The case studies included the construction of the Tanzam Highway, the improvement of the Port of Mogadiscio, and the construction of a section of the Great East Road from Zambia to Malawi. All probably done in the late 1960’s

    Regards, Geoff Dyce

Leave a comment

Leave a Reply to Geoff Dyce Cancel reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: