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©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004 -2008 All rights reserved
P r o v i d i n g W E A L T H C A R E
ARE YOU MODELING WHAT YOU ARE YOU MODELING WHAT YOU INTENDED?INTENDED?
Presented by:
David B. Loeper, CIMA®, CIMC®
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 2
What are Capital Market Assumptions (CMAs) Anyway?
For Purposes of Monte Carlo Simulation OR Optimization:
The Average (mean, arithmetic mean) of Millions of Returns• Center of the distribution
The Standard Deviation of Returns (uncertainty)• Extent and frequency returns vary from the mean
The Correlation of Returns to Other Assets• Degree of association between two random variables
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 3
What are Capital Market Assumptions (CMAs) Anyway?
For Purposes of Monte Carlo Simulation OR Optimization:
The Average (mean, arithmatic mean) of Millions of Returns• Center of the distribution
The Standard Deviation of Returns (uncertainty)• Extent and frequency returns vary from the mean
The Correlation of Returns to Other Assets• Degree of association between two random variables
Together, these define the shape of a RANDOM distribution and ARE NOT A FIXED
RELATIONSHIP in A Monte Carlo TRIAL
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 4
Statisticians draw these distributions as a bell curve(Log normal distributions have a slightly longer tail at one end)
Extent
FrequencyMean
Standard Deviation
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 5
Statisticians draw these distributions as a bell curveThe bell curve can define AN ASSET CLASS
High RiskAsset Class
LowRisk
AssetClass
Low Mean & Risk
High Mean & Risk
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 6
Statisticians draw these distributions as a bell curveThe bell curve can define AN ASSET CLASSOr A PORTFOLIO when two or more classes are combined (based on the correlation between the two)
50%
Mean
More EfficientPortfolio
High RiskAsset Class
LowRisk
AssetClass
Low Mean
High Mean
50%
Degree of Covariance
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 7
Imagine the “bell” flipped over and filled with a million numbers
Extent
FrequencyMean
10 1114
24
7
1 188 129
-3
-11
-22
28
35
45
9 1311 192
5 10-1 12 16 26
-913
274 752-38
-45 61-5-21
-28
381811
26141284 41 48
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 8
Imagine the “bell” flipped over and filled with a million numbersThe CMAs define the population of numbers in the “bell”
Extent
FrequencyMean
10
-3
1114
24
52
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 9
The CMAs define the population of numbers in the “bell”If we stirred them, blind folded you, & asked you to pickA SMALL percentage of the numbersWhat’s your chance of picking?….
Extent
FrequencyMean
10
-3
1114
24
52
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Just these?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 10
The CMAs define the population of numbers in the “bell”If we stirred them, blind folded you, & asked you to pickA SMALL percentage of the numbersWhat’s your chance of picking?….
Extent
FrequencyMean
10
-3
1114
24
52
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Just these?
Or, Just
these?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 11
The CMAs define the population of numbers in the “bell”What’s your chance of picking?….
Extent
FrequencyMean
10
-3
1114
24
52
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Just these?
Or, Just
these?
Monte Carlo Simulates this
random “picking”
BASED ON THE BELL
(bowl) DEFINED BY
THE CMAs
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 12
The CMAs define the population of numbers in the “bell”
Extent
FrequencyMean
10
-3
1114
24
52
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Just these?
5% Chance
Or, Just these?
5% Chance
In Seeking RATIONAL confidence,
WITHOUT undue sacrifice, do we advise clients to
live their life based on
REMOTE EXTREMES
THAT NEVER HAPPENED?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 13
The CMAs define the population of numbers in the “bell”
Extent
FrequencyMean
10
-3
1114
24
52
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Just these?
5% Chance
Or, Just these?
5% Chance
In Seeking RATIONAL confidence,
WITHOUT undue sacrifice do we advise clients to
live their life based on
REMOTE EXTREMES?
Or REASONABLE CONFIDENCE?
<18% Chance or 82% Confidence of EXCEEDING
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 14
The CMAs define the population of numbers in the “bell”
Extent
FrequencyMean
10
-3
1114
24
52
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Just these?
Or, Just
these?
But, IF WE MAKE POOR
ASSUMPTIONS in the SHAPE of
the Bell, we could be CREATING:
UNDUE SACRIFICE
orTOO MUCH
UNCERTAINTY
10%<18% Chance
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 15
The CMAs define the population of numbers in the “bell”IN THIS CASE, 82% Confidence is likely FAR worse than any market we have ever seen! SACRIFICE!!
Extent
FrequencyMean
10
-3
1114
24
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Missing only a few returns (some
HIGH ones) changes ALL of
the odds
7%Only 50% Confidence of
EXCEEDING What Had Been 82%
Remote outcome no
longer within population
52
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 16
The CMAs define the population of numbers in the “bell” 82% Confidence of DOING ABOVE AVERAGE?!TOO MUCH UNCERTAINTY
Extent
Frequency
Mean
10
-3
1114
24
-11
-22-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21-28
13274
381811
7
26141284 41 48
Missing only a few returns (some
LOW ones) changes ALL of
the odds
13% 82% Confidence of EXCEEDING What Had Been only 50%
Remote outcome no
longer within population
Higher Confidence of
previously remote extreme
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 17
CRITICAL POINTS TO UNDERSTAND
With more COMPLETE populations, we can understand:
Where reasonable confidence falls
Remote extremes (those possible but never seen events)
It is intuitive that if you select a small sample, it is very unlikely they will ALL be one extreme or the other
Extent
FrequencyMean
10
-3
11
14
24
52
-11
-22
-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21
-28
13274
381811
7
26141284 41 48
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 18
CRITICAL POINTS TO UNDERSTAND
With more COMPLETE populations, we can understand:
Where reasonable confidence falls
Remote extremes (those possible but never seen events)
It is intuitive that if you select a small sample, it is very unlikely they will all be one extreme or the other
Extent
FrequencyMean
10
-3
11
14
24
52
-11
-22
-38
-45
7
1 18
28
35
45
61
8
9
12
1311 19
9
2
5 10-1 12 16 26
-9
-5-21
-28
13274
381811
7
26141284 41 48
What is harder to understand is how unlikely it is that a LARGER sample would be representative of the entire population…Thus skewed…or fooled?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 19
We Can Easily Be Fooled (by randomness)
How Many Of You Think a Compound Return for Large Cap should be 10% or less?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 20
We Can Easily Be Fooled (by randomness)
How Many Of You Think a Compound Return for Large Cap should be 10% or less?
30 Years 1974- 2003: 12.08%
30 Years 1973-2002: 10.55%
30 Years 1927-1956:
Think we should be careful in using a 30 year data set? ONE year changed compound return by
1.5%!!!!
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 21
We Can Easily Be Fooled (by randomness)
How Many Of You Think a Compound Return for Large Cap should be 10% or less?
30 Years 1974- 2003: 12.08%30 Years 1973-2002: 10.55%30 Years 1927-1956: 10.06% (expecting depression as NORM?)
20% of Historical 30 Year Periods <10%50% of Historical 30 Year Periods >10.82%51% of Historical 30 Year Periods >10.85% (monthly data)Our CMAs: 12.32% (mean) & 18.38% SD= 10.85% CompoundOur CMAs at 77th %-tile: 8.30% at 87th%-tile: 7.17%Worst 30 Years of History (annual data): 8.47% (1929-1958)Worst 30 Years of History (monthly data): 7.17%
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 22
We Can Easily Be Fooled (by randomness)
How Many Of You Think a Compound Return for Large Cap should be 10% or less?
30 Years 1974- 2003: 12.08%30 Years 1973-2002: 10.55%30 Years 1927-1956: 10.06% (expecting depression as NORM?)
20% of Historical 30 Year Periods <10%50% of Historical 30 Year Periods >10.82%51% of Historical 30 Year Periods >10.85% (monthly data)Our CMAs: 12.32% (mean) & 18.38% SD= 10.85% CompoundOur CMAs at 77th %-tile: 8.30% at 87th%-tile: 7.17%Worst 30 Years of History (annual data): 8.47% (1929-1958)Worst 30 Years of History (monthly data): 7.17%
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 23
RANDOMNESS Doesn’t Look Random!
How Many Of You Think a Compound Return for Large Cap should be 10% or less?
30 Years 1974- 2003: 12.08%30 Years 1973-2002: 10.55%30 Years 1927-1956: 10.06% (expecting depression as NORM?)
20% of Historical 30 Year Periods <10%50% of Historical 30 Year Periods >10.82%51% of Historical 30 Year Periods >10.85% (monthly data)Our CMAs: 12.32% (mean) & 18.38% SD= 10.85% CompoundOur CMAs at 77th %-tile: 8.30% at 87th%-tile: 7.17%Worst 30 Years of History (annual data): 8.47% (1929-1958)Worst 30 Years of History (monthly data): 7.17%
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 24
RANDOMNESS Fooling Us? Have you been fooled by?…
RECENT low returns?Previously high returns (14% assumptions 5 years ago)Data sets that are too small to have any confidence in
assumptions? (20-30 Years? 10 Years?)• One trading discipline (MLM index)• “New” asset classes (foreign stocks, mid cap, growth/value,
hedge funds)
“Seeing Cycles or Streaks” in Random Data?• Roulette Wheel Spun 15 reds in a row!
– “Red Streak” Or “Black is Overdue”(As if the ball remembers where it fell)
• Growth & Value “Cycle”
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 25
Familiar with Growth & Value Cycles?
Relative Trailing 3 Year Returns - Growth vs. Value
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
Jan-
81
Jan-
82
Jan-
83
Jan-
84
Jan-
85
Jan-
86
Jan-
87
Jan-
88
Jan-
89
Jan-
90
Jan-
91
Jan-
92
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
3 Year Period Ending
Pe
form
an
ce
vs
. La
rge
Ca
p
Growth
ValueValue Outperforms
Growth OutperformsHEADS
TAILSHeadsTails
Heads vs. Tails
Ra
nd
om
Re
turn
s
Trailing 12 Flips
Flip# 12 24 36 48 60 72 84 96
Heads vs.TailsRANDOMNESS?
RandomnessDOES NOT appear to be
Random!
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 26
Your Advice (output) is only as good as the input… (Capital Market Assumptions)
If we are going to make the most of the one life each client has, then we must:
»Have comfort & confidence in achieving thegoals each client VALUES»Which therefore requires avoiding undue sacrifice to their lifestyle»And would include avoiding unnecessary investment risk (risk=concern=contradiction to comfort)
These are the premises of what we call: Wealthcare
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 27
Capital Market Assumptions SHOULD NOT CONTRADICT Wealthcare PREMISES…If we are too conservative, the price to the client’s life is: NEARLY
CERTAIN UNDUE LIFESTYLE SACRIFICE
REMEMBER:
1. How we were fooled by recent history?
2. How missing a few data points changed ALL the outcomes
3. How ONE YEAR of data changed the trailing returns (1.5%)
4. How reasonably large samples can be very skewed?
5. How our brains are “wired” to see streaks & cycles in random data?
To avoid UNDUE SACRIFICE, we should avoid being too conservative
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 28
Client Desires Maximum Income and has no desire to leave more than $1 million estate:Which is Wealthcare? PRICE OF BEING TOO CONSERVATIVE!
$43,000 retirement income and 83% chance of exceeding$1 million estate with (Our CMAs):
-90% chance of exceeding $450k estate?-75% chance of exceeding $1.5 million estate?
OR…
$24,000 retirement income, also 83% confidence but 2% lower return assumption than our CMAs:
-96.5% chance of exceeding $1 million?-90% chance of exceeding $1.5 million?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 29
Client Desires Maximum Income and has no desire to leave more than $1 million estate:Which is Wealthcare? PRICE OF TOO CONSERVATIVE!
$43,000 retirement income and 83% chance of exceeding$1 million estate with (Our CMAs):
-90% chance of exceeding $450k estate?-75% chance of exceeding $1.5 million estate?
OR…
$24,000 retirement income, also 83% confidence but 2% lower return assumption than our CMAs:
chance of exceeding $1 million?-90% chance of exceeding $1.5 million?Being too conservative prioritizes estate above all else!
With $43k income starting in 1926, they’d have an $875K
estate
With $24k income starting in 1926, they’d have a
$2.6 million estate
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 30
I’d be very uncomfortable targeting low 80ish confidence with return assumptions less than ours…Nearly certain sacrifice!
I’m fairly confident of our assumptions for stocks, bonds & cash because there is a lot of data to validate & test reasonableness
Funny thing, a lot of the advisors that think our assumptions are “too high” (currently) or “too low” (eight years ago) despite all the data, turn around and complain about our assumptions for “new classes” despite NOT having enough data to validate & test these “new classes”
Isn’t a premise of Wealthcare having RATIONAL CONFIDENCE?
What happens to CONFIDENCE in DELIVERING the client’s goals when we make ASSUMPTIONS about “classes” we do not have the data to validate???
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 31
I’d be very uncomfortable targeting low 80ish confidence with return assumptions less than ours…Nearly certain sacrifice!
I’m fairly confident of our assumptions for stocks, bonds & cash because there is a lot of data to validate & test reasonableness
Funny thing, a lot of the advisors that think our assumptions are “too high” (currently) or “too low” (five years ago) despite all the data, turn around and complain about our assumptions for “new classes” despite NOT having enough data to validate & test these “new classes”
Isn’t a premise of Wealthcare having RATIONAL CONFIDENCE?
What happens to CONFIDENCE in DELIVERING the client’s goals when we make ASSUMPTIONS about “classes” we do not have the data to validate and test reasonableness???
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 32
First Question Would Be…What Explains 90%+ Of The Variance Of Returns? (to see if targeted confidence is in the ballpark?)
ANSWER: Asset Allocation
Source: Two Studies by Brinson, Beebower & Hood
Asset Allocation TO WHAT?
STOCKS, BONDS & CASH
LESS THAN 10% of variance was explained by small cap, midcap, growth, value, foreign, real estate, etc.
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 33
First Question Would Be…What Explains 90%+ Of The Variance Of Returns? (to see if targeted confidence is in the ballpark?)
ANSWER: Asset Allocation
Source: Two Studies by Brinson, Beebower & Hood
Asset Allocation TO WHAT?
STOCKS, BONDS & CASH
LESS THAN 10% of variance was explained by small cap, midcap, growth, value, foreign, real estate, etc.
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 34
Sample Client Confidence with 100% Large Cap as Investment Policy:
Based upon randomizing actual historical returns from ’26-’02 1000 times
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 35
How big a difference do you think it would make if the client were OVERWEIGHTED by 60% to Small Cap?
Based upon randomizing actual historical returns from ’26-’02 1000 times
60% Small/40% Large82%
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 36
Shouldn’t it make a HUGE difference???It does…so long as we are planning on coin flip odds…
Based upon randomizing actual historical returns from ’26-’02 1000 times
60% Small/40% Large82%
54% 60% Small/40% Large
45% 100% Large
Assuming you consider 9 pts of confidence “HUGE” near the median
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 37
Measuring with a micrometer…cutting with a chain saw…
Would You Get Different Results With These Allocations?
Asset Class #1 #2 #3 #4
Large 40% 10% 0% 20%Large Value 0% 15% 20% 10%Large Growth 0% 15% 20% 10%Small 60% 0% 40% 10%Small Value 0% 30% 10% 25%Small Growth 0% 30% 10% 25%
SHOULD YOU?SHOULD YOU?THEY ARE ALL THE SAME!THEY ARE ALL THE SAME!
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 38
Provided you use appropriate indices, your results would be statistical equivalents – 10 Years Ending 2002
Would You Get Different Results With These Allocations?
Allocations: #1 #2 #3 #4
Large 40% 10% 0% 20%Large Value 0% 15% 20% 10%Large Growth 0% 15% 20% 10%Small 60% 0% 40% 10%Small Value 0% 30% 10% 25%Small Growth 0% 30% 10% 25%
Mean 9.46 9.35 9.39 9.37Compound 8.22 8.13 8.16 8.15Standard Deviation 16.59 16.46 16.52 16.49Sample Confidence 49% 48% 48% 48%
Are we getting better assumptions by slicing the pie into more pieces?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 39
Or are we increasing our estimation error by limiting our data set?
Would You Get Different Results With These Allocations?
Allocation: #1 #2 #3 #4
11 Years 2003:Mean 10.62 10.57 10.63 10.58Compound 9.45 9.41 9.46 9.42Standard Deviation 16.21 16.14 16.20 16.14Sample Confidence 64% 63% 64% 63%
10 Years 2002:Mean 9.46 9.35 9.39 9.37Compound 8.22 8.13 8.16 8.15Standard Deviation 16.59 16.46 16.52 16.49Sample Confidence 49% 48% 48% 48%
Since the results are statistically the same between the allocations…
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 40
Would You Get Different Results With These Allocations?
Allocation: #1 #2 #3 #4
11 Years 2003:11 Years 2003 Mean: 10.62 10.57 10.63 10.58Sample Confidence 64% 63% 64% 63%
10 Years 2002:Mean 9.46 9.35 9.39 9.37Compound 8.22 8.13 8.16 8.15Standard Deviation 16.59 16.46 16.52 16.49Sample Confidence 49% 48% 48% 48%
Since the results are statistically the same between the allocations…
25 Years 2000: 18.13%
Sample Confidence 99%
Which “Error” Reduces My OVERALL Confidence More?
Ignoring Subclasses?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 41
Would You Get Different Results With These Allocations?
Allocation: #1 #2 #3 #4
11 Years 2003:11 Year 2003 Mean: 10.62 10.57 10.63 10.58Sample Confidence 64% 63% 64% 63%
10 Year 2002:Mean 9.46 9.35 9.39 9.37Compound 8.22 8.13 8.16 8.15Standard Deviation 16.59 16.46 16.52 16.49Sample Confidence 49% 48% 48% 48%
Since the results are statistically the same between the allocations…
25 Year Mean 2000: 18.13%
Sample Confidence 99%
Which “Error” Reduces My OVERALL Confidence More?
Ignoring Subclasses? +/- 1%
Or ignoring the effect of limiting
my sample population so I can
include Sub- Classes?
+/- 50%+/- 15%
+/- 35%
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P r o v i d i n g W E A L T H C A R E PAGE 42
Making assumptions from limited data, usually has the opposite effect of excessive conservatism
Instead of nearly certain sacrifice…
We MIGHT be subjecting the client to:TOO MUCH UNCERTAINTY
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 43
Making assumptions from limited data, usually has the opposite effect of excessive conservatism
Instead of nearly certain sacrifice…
We MIGHT be subjecting the client to:TOO MUCH UNCERTAINTY
If the effect of “new classes” on the overall portfolio is 1-2% standard deviation and/or 50-100 bps of return…
You could very well be assuming the value of the “new” class is the same as moving the 50th %-tile to the comfort zone!
HOW CAN YOU ASSUME THAT?!
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 44
Making assumptions from limited data, usually has the opposite effect of excessive conservatism
Instead of nearly certain sacrifice…
We MIGHT be subjecting the client to:TOO MUCH UNCERTAINTY
If the effect of “new classes” on the overall portfolio is 1-2% standard deviation and/or 50-100 bps of return…
You could very well be assuming the value of the “new” class is the same a moving the 50th %-tile to the comfort zone!
HOW CAN YOU ASSUME THAT?!
The best evidence your assumptions are wrong about a class, come from Mean Variance Optimizers…
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P r o v i d i n g W E A L T H C A R E PAGE 45
If the results of an MVO are “Wacky”
And you obviously need to constrain it because it shows:
Everyone holding stocks (we have good data) is stupid
But should own managed futures or hedge funds (we have little data) and is therefore “enlightened”
There is probably a stupid assumption in there somewhere…
But Dave, isn’t that why optimizers have constraint inputs?
A lesson in Algebra…
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P r o v i d i n g W E A L T H C A R E PAGE 46
The output is only as good as the input… (Capital Market Assumptions)
If you get wacky unconstrained allocations,IT MEANS YOUR INPUTS ARE WRONG!
If you have to constrain your optimizer to avoid “wacky” results, YOUR INPUTS ARE WRONG!
A lesson in Algebra… Solve this equation: 4x=4
x=1
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P r o v i d i n g W E A L T H C A R E PAGE 47
Now, solve our simple equation but constrain x tobe < or = to .5 (just like an optimizer constraint)
If you have to constrain your optimizer to avoid “wacky” results, YOUR INPUTS ARE WRONG!
A lesson in Algebra… Solve this equation: 4x=4 4x=4
x=1 If x is < or = to .5 then x =.5
OR 2=4
A lesson in Algebra… Solve this equation: 4x=4 4x=4
x=1 If x is < or = to .5 then
x =.5
OR 2=4
The output is only as good as the input… (Capital Market Assumptions)
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 48
Now, solve our simple equation but constrain x tobe < or = to .5 (just like an optimizer constraint)
If you have to constrain your optimizer to avoid “wacky” results, YOUR INPUTS ARE WRONG!
A lesson in Algebra… Solve this equation: 4x=4 4x=4
x=1 If x is < or = to .5 then x =.5
OR 2=4
A lesson in Algebra… Solve this equation: 4x=4 4x=4
x=1 If x is < or = to .5 then
x =.5
OR 2=4
The output is only as good as the input… (Capital Market Assumptions)
ANY constrained allocation is as silly as
saying 2=4!
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 49
Finally, What About Forecasts? Mean Reversion?
Forecasts (mean reversion is just a forecast by another name) do not mix well with measuring confidence in random outcomes.
This is not to say you are unskilled at forecasting…
But, what is the confidence level measuring if it was based on a distribution created by a forecast?
Long Term Nature of Market
Worst of History
Best of History
Median 10.85%
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 50
Finally, What About Forecasts? Mean Reversion?
Forecasts (mean reversion is just a forecast by another name) do not mix well with measuring confidence in random outcomes.
This is not to say you are unskilled at forecasting…
But, what is the confidence level measuring if it was based on a distribution created by a forecast?
Long Term Nature of Market
Worst of History
Best of History
Median 10.85%
Best of history near “norm”?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 51
Finally, What About Forecasts? Mean Reversion?
Forecasts (mean reversion is just a forecast by another name) do not mix well with measuring confidence in random outcomes.
This is not to say you are unskilled at forecasting…
But, what is the confidence level measuring if it was based on a distribution created by a forecast?
Long Term Nature of Market
Worst of History
Best of History
Median 10.85%
Best of history near “norm”?Worst of history near “norm”?
Effect of +/- 2.5%
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P r o v i d i n g W E A L T H C A R E PAGE 52
Which mean are we reverting to?
Market Returns Ending in 2003:
5 Years, bottom 10%-tile of all 5 year periods» Raise Assumption?
10 Years, 51st %-tile of all 10 year periods» Keep the Same Assumption?
25 Years, top 16%-tile of all 25 year periods» Lower Assumption?
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 53
So, how can we be confident about our CMAs for all the asset classes???
WE CAN’T!!!
But…
The “main driver” is stocks, bonds and cash• There we have a lot of good data• We have reasonable confidence in the assumptions• And it is how we invest• Other classes with less evidence cannot by
definition do anything other than introduce more uncertainty (risk)
Isn’t Wealthcare about avoiding unnecessary risk?
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P r o v i d i n g W E A L T H C A R E PAGE 54
How our assumptions are built…
For classes with a lot of good data (i.e. domestic stocks, bonds & cash)• Risk & Return= Average of 700+ 10 year periods• Correlations based on all historical data• Tested in engine (30,000 simulated years vs. 76 years of history)
• Extremes of simulations wider than history (based on SD)• Middle of simulated distribution near middle of historical
dataFor other assets…
• If possible, use a proxy (i.e. foreign stocks are still stocks)• Adjust for added uncertainty (i.e. currency risk for foreign,
limited data for alternative classes)• Use correlations but test with a Cholesky decomposition• Perform MVO test (i.e. adjust as needed to avoid excessive
assumed alpha but still shows some incremental value)
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 55
How our assumptions are built…
For classes with a lot of good data (i.e. domestic stocks, bonds & cash)• Risk & Return= Average of 700+ 10 year periods• Correlations based on all historical data• Tested in engine (30,000 simulated years vs. 76 years of history)
• Extremes of simulations wider than history (based on SD)• Middle of simulated distribution near middle of historical
dataFor other assets…
• If possible, use a proxy (i.e. foreign stocks are still stocks)• Adjust for added uncertainty (i.e. currency risk for foreign,
limited data for alternative classes)• Use correlations but test with a Cholesky decomposition• Perform MVO test (i.e. adjust as needed to avoid excessive
assumed alpha but still shows some incremental value)
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 56
In summary…
If we are really providing:
Confidence in exceeding goals, without undue sacrifice or unnecessary risk…
We cannot bet our clients’ future, or worse, misrepresent the confidence level based on:
» Skewed data» Lack of evidence» Hope or Prophesies… » These all contradict the premises of Wealthcare
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 57
In summary…
If we are really providing:
Confidence in exceeding goals, without undue sacrifice or unnecessary risk…
We cannot bet our clients’ future, or worse, misrepresent the confidence level based on:
» Skewed data» Lack of evidence» Hope or Prophesies… » These all contradict the premises of Wealthcare
©Copyright Financeware, Inc., d/b/a Wealthcare Capital Management 2004-2008 All rights reserved
P r o v i d i n g W E A L T H C A R E PAGE 58
Questions?