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This chapter is from the book

Try Again

That night at Starbucks, I decided to try again. Something was nagging at me. A piece was missing. I knew that volatility affects stock price simulations. The more volatile, the more the distribution of prices is dragged down. But I had not included anything in this spreadsheet to account for that.

I was aware of the fact that, in Monte Carlo simulations, adjustments are made to the distribution being sampled so that returns are not overstated. I wondered if that was what I needed to add.

I went back to the book. On page 597, McDonald said:

  • [W]e need to subtract 1/2 times the variance.

That was the term I had been thinking about.

I wrote the following on a napkin:

  • Mean − 1/2 variance = 0.0% − 0.5 × 0.302 = 0 − .5 × .09 = –0.045 = –4.5%

Worth a shot. So I plugged that into the spreadsheet.

It worked. Then I tried using different assumptions, and it still worked. I still thought it was too easy to be right, but this time I couldn’t show that it was wrong.

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