©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2003-2008 All rights reserved P r o v i d i n g W E A L T H C A R E W E A L T H C A R

©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2003-2008 All rights reserved

P r o v i d i n g W E A L T H C A R E

W E A L T H C A R EW E A L T H C A R EManaging Portfolio Managing Portfolio

UncertaintyUncertainty

Presented by:

David B. Loeper, CIMA®, CIMC®


P r o v i d i n g W E A L T H C A R E PAGE 2

Let’s Start With A Simple Test…Write Down Your Answers…

Question #1:Would a Wealthcare Plan with 20% Confidence Be Sufficient?a) No b) YesWhy?

Question #2:Would you INTENTIONALLY mislead a client/prospect about their

confidence level?a) No b) Yes

Question #3:If you were UNINTENTIONALLY MISLEADING THEM, would you

want to correct it? a) No b) Yes



Let’s Start With A Simple Test…Write Down Your Answers…

Question #4:Would you consider it misleading if an advisor told a client they

had 80% confidence, but in reality they had only 63%-71% confidence?

a) No b) YesWhy?

Question #5:Have you ever had a fund/manager that significantly

underperformed the market?a) No b) Yes

Question #6:When you picked them, were you seeking an investment that

would perform poorly? a) No b) YesIf No, then why did you pick them and what went wrong?



Answer Key#1 – Is 20% Confidence Enough?

a) NoWhy? – Because the stakes are too high, the client only has ONE

LIFE





LIFE

#2 – Would you INTENTIONALLY mislead a client?a) No – If you answered “Yes” you may be excused





LIFE


#3 – If you were UNINTENTIONALLY misleading clients, would you correct it?b) Yes – If you answered “No” you may be excused





LIFE



#4 – Is it misleading to tell a client they are in the comfort zone when they really are well below the comfort zone?

b) Yes – If you answered “No”, you may be excused





LIFE





#5 – Have you ever had a fund/manager that significantly underperformed the market?

b) Yes – If you answered “No”, you are either: Lucky, Inexperienced, Kidding Yourself, a Liar… or…..Brilliant





LIFE





#5 – Have you ever had a fund/manager that significantly underperformed the market?

b) Yes – If you answered “No”, you are either: Lucky, Inexperienced, Kidding Yourself, a Liar… or…..Brilliant

#6 – Were you seeking an investment that would perform poorly?b) Yes – you may be excused

No…Then What Went Wrong?SOMETHING



BOTH sides use the same “evidence” as support for their position:

For Example: Universe Rank – Market at 40th%-tile:

“Passive…therefore” • passive will outperform 60% (or so) of active managers

“Active…therefore” • some managers have skill and we can pick them

Who is right? Is the evidence PROOF or just data? What is the CAUSE?

BOTH perspectives on the “evidence” require accepting other UNPROVEN premises if they are to be valid EVIDENCE:

Passive: Requires that past performance is indication of future resultsThis has not be proven…therefore the “passive therefore” is invalid

Active: Requires that the CAUSE of out-performing to be skill and not luckEquivalent of saying that someone that flipped heads six out of ten coin flips is better than average at flipping heads!?

In money management we do not know whether the cause was skill or luck…(in coin flips we know it is luck) therefore unless we can PROVE skill the “active therefore” is invalid

The Active versus Passive Debate (click here for white paper)



The Active versus Passive Debate (click here for white paper)

BOTH sides use the same “evidence” as support for their position:

Efficient Market Theory:

Passive: Markets are efficient and any “incorrect pricing” is quickly corrected, therefore one cannot consistently find inefficiently priced securities.

Active: Most money is actively invested, and people wouldn’t do that if markets were efficient, and “some” securities are not as efficiently priced (i.e. small cap, foreign).

Sharpe’s Mathematics of Active Management:

Passive: In the end, the market must equal itself! The average dollar invested must equal the market less expenses.

Active: That’s why we don’t pick average managers…we pick above average!

If you have a debate and both sides use the same “evidence” to prove their contradicting conclusions, either the conclusion or the evidence should be dismissed



Do you understand timing Risk?

Year

Projected Portfolio Values

12.15%

» Investor with $2 million in an Aggressive taxable portfolio

» $118k retirement income» 30 year plan

» Do not dip into principal in real terms» Assuming 12.15% return EVERY year» Default tax & inflation assumptions: » Ending Value: $2,062,442



That represented the 50th-percentile result…an average…one of many potential outcomes…Timing risk is exposed by including UNCERTAINTY:



» Do not dip into principal in real terms» Assuming 12.15% return EVERY year» Default tax & inflation assumptions:

» Ending Value: Broke in year 8 to more than $29mil

Year



That represented the 50th-percentile result…an average…one of many potential outcomes…Timing risk is exposed by including UNCERTAINTY:



» Do not dip into principal in real terms» Assuming 12.15% return EVERY year» Default tax & inflation assumptions:

» Ending Value: Broke in year 8 to more than $29mil

Year

Simplified to their

confidence… comfort (or lack

thereof)



Do you understand the difference between Average Return (arithmetic mean), Compound Return (geometric mean) and how uncertainty affects them?

EXAMPLE 1: Average Return: 20% with no variance

% Return $ Return Ending ValueStart $100Year 1: 20% $20.00 $120Year 2: 20% $24.00 $144 Compound = 20.00%






EXAMPLE 2: Average Return: 20% with SOME variance

% Return $ Return Ending ValueStart $100Year 1: 39% $39.00 $139Year 2: 1% $1.39 $140.39 Compound = 18.48%






EXAMPLE 2: Average Return: 20% with SOME variance

% Return $ Return Ending ValueStart $100Year 1: 39% $39.00 $139Year 2: 1% $1.39 $140.39 Compound = 18.48%

EXAMPLE 3Average Return: 20% with WIDE variance

% Return $ Return Ending ValueStart $100Year 1: 60% $60.00 $160Year 2: -20% -$32.00 $128 Compound = 13.14%



Compound Return: 12.15%

Based on Modeling a CERTAIN AVERAGE (arithmetic mean) of 13.8%

And Standard Deviation (extent returns will vary from their average) of 19.6%

Let’s Examine the confidence level of our example client…

But make an assumption that we are CERTAIN that we will AVERAGE a 2% Alpha (market out-performance)

For our example client, the variance in the aggressive portfolio made the 50th-percentile COMPOUND (geometric mean) return…



This extra performance dramatically improves the investor’sconfidence and comfort of producing:

$118,000 a year in inflation adjusted incomeNet after tax (default assumptions – 100% turnover, 50% of gains long term)$2 Million Ending Value in spending power

Confidence (comfort) equaling the market:



This extra performance dramatically improves the investor’sconfidence and comfort of producing:


Confidence (comfort) equaling the market:

Confidence WITH 2% AlphaEACH YEAR

Thus why you select investments that outperform by 2% every year



You may even improve on this by selecting Tax Efficient investments that outperform by 2% every year:





You may even improve on this by selecting Tax Efficient investments that outperform by 2% every year:



Tax Efficient (15% turnover and 100% of gains long term) with

2% Alpha each year:

Your advice puts them in the comfort zone!!!



Active Management is a VERY GOOD THING and CLEARLY we should do it when:




We are CERTAIN we will AVERAGE 2% more than the marketAnd we do exactly that each & every year…

Equal Market:


2% Alpha each year:





Equal Market:


2% Alpha each year:

Does Anyone See Any Problems In This?





Two Obvious PROBLEMS:

» First, we are not 100% certain we will AVERAGE 2% More than the market (we will ignore this for now and assume you all will average 2% more than the market anyway)

» Second, there is TIMING RISK uncertainty in our active management

(sometimes we out-perform by a lot, sometimes a little, and every once in a while…we might even under perform by a little)

What happens when we ignore TIMING RISK?



Measuring the UNCERTAINTY of Active Management Timing RISK

For an aggressive portfolio, how far might returns vary from the market in one year?

Sample Universe 8.0% Spread from average (1SD) With 2% Alpha Implies:

In Favor Out of Favor NormalRelative Performance +10.36% -5.01% +1.46

Average of all markets: +2%




For an aggressive portfolio, how far might returns vary from the market in one year?

Sample Universe 8.0% Spread from average (1SD) With 2% Alpha Implies:

In Favor Out of Favor NormalRelative Performance +10.36% -5.01% +1.46

Average of all markets: +2%

Is this reasonable to you?

Which is a more realistic model?

A) Assume we beat the market by the exact same amount each year?B) Assume we will beat the market by 2% on average, but our market

relative performance will vary from year to year?




Effect of Timing Risk for Market Relative Performance:

2% Average Alpha & 8% Standard Deviation0 7.00%

5 4.02%

10 3.51%

15 3.21%

20 2.88%

25 2.65%

30 2.43%

35 2.19%

40 2.01%

45 1.80%

50 1.61%

55 1.44%

60 1.21%

65 1.01%

70 0.87%

75 0.64%

80 0.39%

85 0.13%

90 -0.18%

95 -0.69%

100 -3.07%

Percentile

MarketRelativeReturn

Market Relative Performance INCLUDING TIMING RISK – 30 Years:

Despite AVERAGING 2% above market

The compounding effect of that uncertainty leaves us a 50% chance of only beating the market by

1.61%:

AND exposes us to the Timing Risk we previously ignored

A 10% Chance of Underperforming even though on average we outperformed



Just as Considering TIMING RISK in plans exposes uncertainty…We can blend the market relative performance variance and measure confidence WITHOUT IGNORING Active Management Timing RISK

Our Sample Client – Tax Efficient Results with CERTAIN 2% Alpha:

Without Timing Risk (Assume 2% Alpha

EACH YEAR)



Just as Considering TIMING RISK in plans exposes uncertainty…We can blend the market relative performance variance and measure confidence WITHOUT IGNORING Active Management Timing RISK


Without Timing Risk (Assume 2% Alpha

EACH YEAR)

WITH Timing Risk (Assume 2% Alpha but there is some variance)




With CERTAINTY of Averaging a 2% Alpha, INCLUDING Active Timing Risk, We Still Add Value on AVERAGE

Our Sample Client – Tax Efficient Results with CERTAIN 2% Alpha:Equal Market:

Just not as much as we thought!




With CERTAINTY of Averaging a 2% Alpha, INCLUDING Active Timing Risk, We Still Add Value on AVERAGE

Our Sample Client – Tax Efficient Results with CERTAIN 2% Alpha:Equal Market:

Just not as much as we thought!

Oops…forgot one thing… In the market portfolio we

assumed 100% turnover and 50% of the gains taxed

as short term





Funny thing about UNCERTAINTY…DESPITE Averaging a 2% Alpha, If We INCLUDE Active Timing Risk, Our VALUE ADD EVAPORATES!

Equal Market, Same Tax Assumptions as

Active:(15% turnover, 100% of

gains as long term)





Passive Management:0.49% NEGATIVE

ALPHA (certain underperformance), 30

bps variance from market & tax efficient

Of course, we can’t invest in the market for free and even index funds vary from the market a little…




Passive Management:0.49% NEGATIVE

ALPHA (certain underperformance), 30

bps variance from market & tax efficient

Of course, we can’t invest in the market for free and even index funds vary from the market a little…

WHEN WE INCLUDE TIMING RISK… A CERTAIN 2% Alpha adds 3 points of confidence relative to our passively managed portfolio



That ALPHA provides hope of a higher income…

CERTAIN 2% Active Alpha (with timing risk) Vs. OUR Portfolio…Confidence of supporting $168,000 Inflation Adjusted Income:



That ALPHA provides hope of a higher income…

CERTAIN 2% Active Alpha (with timing risk) Vs. OUR Portfolio…Confidence of supporting $168,000 Inflation Adjusted Income:

OUR Passive Management with

CERTAIN negative alpha…

Only a 29% Chance!

ACTIVE INCLUDE TIMING RISK, CERTAIN 2%

Alpha,39% Chance of $168k

Income!



But we do not plan on coin flip odds or worse THAT CONTRADICTS comfort & confidence…

Confidence of supporting $60,000 Inflation Adjusted Income:

Result With Market Results – Tax Efficient

No CostNo Variance From

Market

ACTIVE INCLUDE TIMING RISK, CERTAIN

2% Alpha,

84% Chance of $60,000 Income!



But we do not plan on coin flip odds or worse THAT CONTRADICTS comfort & confidence…

Confidence of supporting $60,000 Inflation Adjusted Income:

ACTIVE INCLUDE TIMING RISK, CERTAIN

2% Alpha,

84% Chance of $60,000 Income!

Price to OUR Passive Management with

CERTAIN negative alpha & some

variance…86% Chance



Didn’t most of us have some investments that under performed?

Do you think you can really pick 10 out of 10 that will AVERAGE 2% more than the market?

All the analysis so far made that assumption

Out of 10 Picks, How Many Will Be Winners?9?8?7?6?5?4?

This is another UNCERTAINTY…and we can model the risk your confidence (or lack thereof) has on the client’s overall confidence

Has Anyone Been Bothered By This CERTAINTY of Averaging a 2% Alpha?




$60,000 incomeTax Efficient Passive

Certain negative alphaSome additional timing risk

relative to the market:

86% Confidence

Active $60,000 incomeTax Efficient, 2% Alpha

PICK 10 OUT OF 10

84% Confidence







86% Confidence


PICK 9 OUT OF 10

81% Confidence







86% Confidence


PICK 8 OUT OF 10

78% Confidence







86% Confidence


PICK 7 OUT OF 10

75% Confidence







86% Confidence


PICK 6 OUT OF 10

72% Confidence







86% Confidence


PICK 5 OUT OF 10

69% Confidence







86% Confidence


HEAVEN FORBID!PICK 4 OUT OF 10

65% Confidence



THIS is WHY WE JOINED THE ENEMY!

NOT BECAUSE OF:Fees, Taxes, Or Where Indices Fall in Universes…

But Because of the PRICE to our clients ONLY life!

Confidence of $60,000 Income-

Tax Efficient Passive: 86%

Active, Tax Efficient 2% Alpha:10 for 10: 84%9 for 10: 81%8 for 10: 78%7 for 10: 75%6 for 10: 72%5 for 10: 69%4 for 10: 65%



The PRICE TO OUR CLIENT’S LIFE IS HUGE! The Price to Active Uncertainty

INCOME TO HAVE SAME CONFIDENCE AS TAX EFFICIENT PASSIVE:

$60,000

Confidence of $60,000 Income-

Tax Efficient Passive: 86%

Active, Tax Efficient 2% Alpha:10 for 10: 84%9 for 10: 81%8 for 10: 78%7 for 10: 75%6 for 10: 72%5 for 10: 69%4 for 10: 65%

$52,000$47,000$40,000$34,000$31,000$30,000$23,000NOT A TYPO!!!

ARE YOU DISCLOSING THIS

RISK!!!???



“But I’m Not Attempting to Out Perform – I’m About Risk Control!”

Actual Allocation Risk Vs. Returns 80 Years Ending 12/31/2005And Wealth Results for "Saver" Wealth Management Plan

Aggressive Growth

Growth

Bal Growth

Balanced

Bal Income

Risk Averse

Superior Selection$22.7 Million Wealth

Management$26.7 Million

7.00%

7.50%

8.00%

8.50%

9.00%

9.50%

10.00%

10.50%

11.00%

11.50%

12.00%

7.00% 12.00% 17.00% 22.00% 27.00%

Risk (SD)

Ret

urn

(G

eom

etri

c)

I’m not looking for this:

I’m Controlling Risk!

Then What’s This???

80 Year Efficient Frontier



The Bottom Line to Your Clients…

If you are implementing with active management:

1. The confidence level represented by MARKET returns is a MATERIAL misrepresentation of the client’s true confidence level» 89% confidence for market – 84% Active, 2% Alpha, Pick 10 of 10» 75% confidence for Active if you pick 7 of 10

(ARE YOU DISCLOSING THIS?)







2. At coin-flip confidence (near 50%-tile), Picking 10 of 10 add 3 pts of confidence versus passive at the same level of income








3. The active bet versus our passive portfolios equates to this…» ASSUMING YOU CAN PICK WINNERS 7 of 10 TIMES IGNORING FEES:

» 20% chance of having 9.2% more income» 50% chance of having 5.5% LESS INCOME» 20% chance of having 29% LESS INCOME

WOULD YOU MAKE THIS BET?

ARE YOU DISCLOSING THIS RISK?

ARE YOU AND YOUR CLIENT CONCIOUSLY ACCEPTING THIS RISK?

OR, ARE YOU ASSUMING THERE IS NO RISK?(like we used to do in financial plans)








3. The active bet versus our passive portfolios equates to this…» ASSUMING YOU CAN PICK WINNERS 7 of 10 TIMES IGNORING FEES:

» 20% chance of having 9.2% more income» 50% chance of having 5.5% LESS INCOME» 20% chance of having 29% LESS INCOME

WOULD YOU MAKE THIS BET?

ARE YOU DISCLOSING THIS RISK?

ARE YOU AND YOUR CLIENT CONCIOUSLY ACCEPTING THIS RISK?

OR, ARE YOU ASSUMING THERE IS NO RISK?(like we used to do in financial plans)



In Summary, The Choice is Yours…

You Can:» Implement in manner that reduces confidence except for the remote probabilities of

a relatively small improvement (20% chance of 9% more income, but 50% chance of less)

» Intentionally mislead your clients about their confidence

» Evade correcting previous unintentionally misleading representations

» Continue to represent they are in the comfort zone when you know the way you implement is putting them below it

» Seek investments that out-perform

» Despite the price to your client’s life of doing so

IS THIS HOW YOU ANSWERED THE QUESTIONS IN THE QUIZ?



You Can:» Implement in manner that reduces confidence except for the remote probabilities of

a relatively small improvement (20% chance of 9% more income, but 50% chance of less)

» Intentionally mislead your clients about their confidence

» Evade correcting previous unintentionally misleading representations

» Continue to represent they are in the comfort zone when you know the way you implement is putting them below it

» Seek investments that out-perform

» Despite the price to your client’s life of doing so

Isn’t there a way of making the most of the only life your client has WITHOUT NEEDLESSLY ACCEPTING THESE RISKS?

DON’T ALL OF THESE ACTIONS (OR INACTIONS) CONTRADICT:Comfort? Confidence? And…AVOIDING: UNDUE SACRIFICE?



You can gamble your client’s future, and your career…

» By representing your value as picking investments(despite the price to the client’s life)



You can gamble your client’s future, and your career…

» By representing your value as picking investments(despite the price to the client’s life)

Or, you can deliver the Wealthcare Value Proposition of making the most of the one life each client has…

Providing confidence & comfort in achieving that which the client uniquely values…

Without accepting undue sacrifices to their lifestyle

And avoiding ANY investment risks (including the bet on active) that DO NOT BUY the client something they value

Questions?

Documents

©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2003-2008 All rights reserved P r o v i d i n g W E A L T H C A R E W E A L T H C A R