What is 'Stochastic Modeling'

Stochastic modeling is a form of financial modeling that includes one or more random variables. The purpose of such modeling is to estimate how probable outcomes are within a forecast to predict conditions for different situations. The Monte Carlo simulation is one example of a stochastic model; when used for portfolio evaluation, various simulations of how a portfolio may perform are developed based on probability distributions of individual stock returns.

BREAKING DOWN 'Stochastic Modeling'

Stochastic modeling presents data, or predicts outcomes, all of which account for certain degrees of unpredictability, or randomness. Stochastic modeling is used in a variety of industries around the world, many of which are dependent on such models for improving business practices or increasing profitability. For example, the insurance industry relies heavily on stochastic modeling to predict the future of company balance sheets. Other industries and fields of study that depend on stochastic modeling include stock investing, statistics, linguistics, biology and even quantum physics.

Understanding the Concept of Stochastic Modeling

To understand the sometimes confusing concept of stochastic modeling, it is helpful to compare it to deterministic modeling. While the former produces a variety of answers, estimations or outcomes, deterministic modeling is the opposite. Under deterministic modeling, there is typically only one solution, or answer, to a problem in most elementary mathematics. Deterministic modeling also typically dictates there is only one set of specific values. Alternatively, stochastic modeling can be likened to adding variations to a complex math problem to see its effect on the solution. This process is then repeated in a number of different ways to produce a number of solutions.

[Stochastic modeling is a powerful forecasting method that can be used to great affect for investing and implementing trading strategies. If you are interested in learning this and other types of financial modeling, check out Investopedia Academy's Financial Modeling Course and master the skills to evaluate any financial project.]

Stochastic Modeling in the Investment World

Stochastic investment models attempt to forecast the variations of prices and returns on assets and asset classes, such as bonds and stocks, over time. In the investment world, stochastic models can be classified differently, having different models for single assets and multiple assets. Such modeling is, much of the time, used for financial planning and actuarial work that allows investors and traders to optimize asset allocation as well as asset-liability management.

The significance of stochastic modeling is extensive and far-reaching. The importance of being able to view a variety of outcomes and factor in a variety of variables is unparalleled, and in some industries, it may mean the success or bankruptcy of a company. Because new variables may come into play at any time, and because the number of variables that may have an effect could be high, stochastic models are sometimes run hundreds or even thousands of times, offering potential outcomes for nearly every situation a business, industry, portfolio or agency may face.

RELATED TERMS
  1. Stochastic Volatility - SV

    Stochastic volatility refers to the fact that the volatility ...
  2. Worden Stochastics

    The Worden Stochastics indicator represents the percentile rank ...
  3. Predictive Modeling

    Predictive modeling is the process of using known results to ...
  4. Financial Modeling

    The process by which a firm constructs a financial representation ...
  5. Stochastic Oscillator

    A technical momentum indicator that compares a security's closing ...
  6. Black's Model

    Black's Model is a variation of the popular Black-Scholes options ...
Related Articles
  1. Trading

    MACD and Stochastic: A Double-Cross Strategy

    Two indicators are usually better than one. Find out how this pairing can enhance your trading.
  2. Trading

    Build a Profitable Trading Model In 7 Easy Steps

    Trading models can provide a powerful tool for building profit. Traders can use and customize existing trading models or build an original model. This article provides seven steps to building ...
  3. Personal Finance

    Discounted cash flows or comparables: Which to use

    DCF and comparables models are widely used in equity valuation, and here we'll explain the pros and cons of each method.
  4. Trading

    Trading Volatile Stocks With Technical Indicators

    Short-term traders seek volatility because of the profit potential. Discover how to find volatile stocks and use technical indicators to trade them.
  5. Personal Finance

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  6. Tech

    Predictive Analytics Drives Return for Investors

    A new industry of predictive analysis has developed to make sense of big data and give investors real-time buy and sell recommendations based on the patterns forming in the data long before traditional ...
  7. Investing

    Why Tesla's Stock May Defy The Skeptics

    Tesla shares could skyrocket if the car maker hits its 2018 production estimates. So far, so good.
  8. Trading

    Breaking Down The Binomial Model To Value An Option

    Find out how to carve your way into this valuation model niche.
  9. Investing

    UBS Maintains Sell Rating on Tesla (TSLA)

    While having more Tesla's on the road may be a good thing for the environment, what it means for the company's fundamentals at this point is unclear.
RELATED FAQS
  1. What is the difference between Stochastic Oscillator and Stochastic Momentum Index?

    Discover how the stochastic oscillator and the Stochastic Momentum Index differ and why the latter is considered a more refined ... Read Answer >>
  2. What are the best technical indicators to complement the Stochastic Oscillator?

    Explore the function of the stochastic oscillator indicator, and discover other technical indicators traders use to complement ... Read Answer >>
  3. Is a Slow Stochastic Effective in Day Trading?

    The good news is that most technical indicators can be adjusted to be of value to a day trader. Read Answer >>
  4. How do I read and interpret an Stochastic Oscillator?

    Understand the basics of the stochastic oscillator and how analysts and traders use this measure of trend momentum to predicts ... Read Answer >>
  5. What's the difference between relative strength index (RSI) and stochastic oscillator?

    Learn about some of the main differences between the relative strength index and the stochastic oscillator, two well-known ... Read Answer >>
Hot Definitions
  1. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  2. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  3. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  4. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  5. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  6. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
Trading Center