Download - Managing Uncertainty In Portfolio Implementation David B. Loeper, CIMA, CIMC Chairman & CEO
Managing Uncertainty In Portfolio Implementation
David B. Loeper, CIMA, CIMCChairman & CEO
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QUESTION #1:Would a Wealthcare Plan with 50-58% Confidence Be Sufficient?a) No b) Yes
Why?
QUESTION #2:Would you INTENTIONALLY mislead a client/prospect about their
confidence level?a) No b) Yes
If you were UNINTENTIONALLY MISLEADING THEM, would you want to correct it?
a) No b) Yes
QUESTION #3:
Let’s Start With A Simple Test…Write Down Your Answers…
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QUESTION #4:Would you consider it “misleading” if an advisor told a client they were in
the comfort zone, but in reality had a 33-50% chance of being in “Sacrifice” or “Uncertainty”?
a) No b) Yes
QUESTION #5:Have you ever had a fund/manager that significantly underperformed the
market?a) No b) Yes
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?
QUESTION #6:
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ANSWER KEY:#1 – Is 58% Confidence Enough?
a) NoWhy? – Because the stakes are too high, the client only has ONE LIFE
#2 – Would you INTENTIONALLY mislead a client?a) No – If you answered “Yes” you may be excused
#3 – If you were UNINTENTIONALLY misleading clients, would you correct it?a) Yes – If you answered “No” you may be excused
#4 – Is it misleading to tell a client they should be comfortable with 33-50% odds of sacrifice or uncertainty?
a) Yes – If you answered “No”, you may be excused
#5 – Have you ever had a fund/manager significantly underperformed the market?a) 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?
a) Yes – you may be excusedb) No…Then What Went Wrong?SOMETHING
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The Active versus Passive Debate (click here for white paper)
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
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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!
Growth & Value Run In Obvious Cycles…
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We All Know How Cyclical Growth & Value Is…SEE WHAT EXISTS
Relative Trailing 3 Year Returns - Growth vs. Value
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
Jan-8
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3 Year Period Ending
Pefo
rman
ce v
s. L
arge
Cap
GrowthValue
Value Outperforms
Growth OutperformsHEADS
TAILSHeadsTails
Heads vs. Tails
Ran
dom
Ret
urns
Trailing 12 Flips
Flip# 12 24 36 48 60 72 84 96
Heads vs.Tails RANDOMNESS
RandomnessDOES NOT appear to be
Random!
Growth and Value are just 1/2 of the market. Just like heads & tails are
one half of a coin.
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The Active versus Passive Debate (click here for white paper)
“92% of drivers that caused car accidents ate carrots in the last six months, therefore, the consumption of carrots contributes to car accidents.”
A high correlation in observations IS NOT the same as cause…most drivers also brush their teeth, kiss their wife, mow their lawn…that doesn’t prove causality!» This manager fell in the top 18% and beat the market seven of the last ten years!
“I’ve seen 1000 white swans and have never seen a black one, therefore all swans are white.”
Everything that happened once, never happened until it happened! » This manager NEVER lost more than 20% (until…), Green Bay NEVER lost a post
season home game (until…)
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Active Versus Passive…The Debate Continues:
Arguments on either side lack:KNOWLEDGE, PROOF, RATIONALE, EVIDENCE, REASON, OBJECTIVITY
Active & Passive Argument Flaws: » Carrots cause car accidents, never seen a black swan, Heads & Tails (growth & value) run in cycles
Major Premises:Passive – Avoiding expense tilts odds in your favorActive – Conscious selection tilts odds in your favor
BUT: Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
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Imagine You Own a Casino…You Like Gamblers!
The Odds Are Tilted In Your Favor In EVERY GameThen why do you set table limits???
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
Number of Gamblers
Table Limits
Number of Bets Per Gambler
Can Mathematically PROVE house
“Take”
# of Gamblers times Average Bet times # of Bets times Take=AVERAGE GROSS
PROFIT
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You Own Casino Roulette…$1 Million in Bets Per Day!
The Odds Are Tilted In Your Favor In EVERY GameThen why do you set table limits???
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
100 Gamblers
$10 Average Bet
1000 Bets Per Gambler
5% Roulette “Take”
100 Gamblers times 1000 Bets= 100,000 Bets times $10 Average Bet= $1 Million
times 5% Take= $50,000 AVERAGE GROSS DAILY PROFIT
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Bill Gates Visits Casino Roulette…Will Bet $1 Million for ONE Bet on Black!
The Odds Are Tilted In Your Favor In EVERY GameThen why do you set table limits???
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
1 Gambler
$1,000,000 Average Bet
1 Bet Per Gambler
5% Roulette “Take”
1 Gambler times 1 Bet= 1 Bet times $1,000,000 Average Bet= $1 Million
times 5% Take= $50,000 AVERAGE GROSS DAILY PROFIT
DO YOU TAKE THIS BET AND CLOSE THE CASINO JUST
FOR HIM?
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Bill Gates Visits Casino Roulette…Will Bet $1 Million in ONE Bet on Black!
The Odds Are Tilted In Your Favor In EVERY GameThen why do you set table limits???
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
1 Gambler
$1,000,000 Average Bet
1 Bet Per Gambler
5% Roulette “Take”
1 Gambler times 1 Bet= 1 Bet times $1,000,000 Average Bet= $1 Million
times 5% Take= $50,000 AVERAGE GROSS DAILY PROFIT
It depends on what you are risking…
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Bill Gates Visits Casino Roulette…Will Bet $1 Million in ONE Bet on Black!
The Odds Are Tilted In Your Favor In EVERY GameThen why do you set table limits???
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
1 Gambler
$1,000,000 Average Bet
1 Bet Per Gambler
5% Roulette “Take”
1 Gambler times 1 Bet= 1 Bet times $1,000,000 Average Bet= $1 Million
times 5% Take= $50,000 AVERAGE GROSS DAILY PROFIT
If you had $1 billion in capital…the STAKES are worth the bet…
But your return on capital stinks ($50k daily profit is $18 million a year/ $1 billion is 1.8% annual
return on your capital)
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Bill Gates Visits Casino Roulette…Will Bet $1 Million in ONE Bet on Black!
The Odds Are Tilted In Your Favor In EVERY GameThen why do you set table limits???
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
1 Gambler
$1,000,000 Average Bet
1 Bet Per Gambler
5% Roulette “Take”
1 Gambler times 1 Bet= 1 Bet times $1,000,000 Average Bet= $1 Million
times 5% Take= $50,000 GROSS DAILY PROFIT
If you had $100 million in capital…the STAKES are also
probably worth the bet…
And your return on capital is good ($50k daily profit is $18 million a year/ $100 million is 18% annual return on your
capital)
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Bill Gates Visits Casino Roulette…Will Bet $1 Million in ONE Bet on Black!
The Odds Are Tilted In Your Favor In EVERY GameThen why do you set table limits???
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
1 Gambler
$1,000,000 Average Bet
1 Bet Per Gambler
5% Roulette “Take”
1 Gambler times 1 Bet= 1 Bet times $1,000,000 Average Bet= $1 Million
times 5% Take= $50,000 GROSS DAILY PROFIT
BUT, if you had only $1 million in capital…the STAKES are too
high…
You would have a 47.4% chance
(18 blacks/38 numbers=47.4%) of closing your doors
for good!!
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What is at stake makes a big difference in terms of your confidence.
What are the odds of the Casino Roulette losing $1,000,000 with:One $1,000,000 bet?= 1 in 2.1 or 47.4%Two $500,000 bets? = 1 in 4.5 or 22.5%Ten $100,000 bets? < 1 in 1,000 Twenty $50,000 bets? < 1 in a million
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What is at stake makes a big difference in terms of your confidence.
What are the odds of the Casino Roulette losing $1,000,000 with:One $1,000,000 bet?= 1 in 2.1 or 47.4%Two $500,000 bets? = 1 in 4.5 or 22.5%Ten $100,000 bets? < 1 in 1,000 Twenty $50,000 bets? < 1 in a million
This is a lot different though than the odds of your casino LOSING money…One $1,000,000 bet?= 1 in 2.1 or 47.4%Twenty $50,000 bets? = About 1 in 3 or 33%One hundred $10,000 bets? = About 1 in 3.6 or 27.6%
This isn’t the main reason they have
table limits
This is…
For investors with odds tilted in their favor (same as casino roulette odds) it is the equivalent of 20-100 years of
investing (20-100 bets)
IS 67-72% CONFIDENCE ENOUGH?
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Some things to think about…
1- What does making the bet buy?»Presumably a better lifestyle»BUT, do you actually get that benefit if you do not plan on winning the bet?
»If you always plan your future based on EQUALLING market returns…Your lifestyle will always be limited to about what a passive implementation would buy
»If you plan on BEATING the market, and after that 20-100 years you ended up losing even though the odds were tilted in your favor (28-33% chance), what happens?
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
In other words…what is at risk?
And what do we get if we win our bet?
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How does active stand up to our test of odds?
Tilting odds ONLY WORKS when:The stakes at risk are low enough to risk gamblingYou have enough chances to make a sufficient number of “bets”
» For the tilted odds to work in your favorYou have sufficient confidence the odds really ARE in your favorAnd the payoff is sufficient to assume the risk
Their ONLY Life
The Client’s Goals & Lifestyle
20-100 Years of Active Bets
Do you KNOW your active odds?
You only get the PAYOFF IF you PLAN ON beating the market…otherwise your life is limited to what PASSIVE would buy…if we
win, what does the gamble buy?
With tilting the active odds the same as Roulette for the Casino,
we still had a 1 in 3 chance of losing the bet…AFTER 20-100
YEARS
What’s at risk?
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Would you make this active bet?…
67%- 72% Confidence you will win (odds tilted like Roulette for 20-100 years)You never enjoy your winnings (plan built based on equaling market)
BUT:»If these odds are sufficient, then we shouldn’t need any higher confidence levels in our plans, would we?»Do we really KNOW the odds are tilted that way?
»Prove it or gamble our client’s lives on it?»We could plan on beating the market to enjoy the reward of the bet
»That might increase the risk if we are wrong though, wouldn’t it?
The Bet On Active:IF management is FREE, AND our selection discipline tilts the odds in our favor (like Roulette)
THEN after 100 Years we have 72% confidence we die with a bigger estate and have a 28% chance of needing to alter our lifestyle along the way PLUS- ANOTHER 20% chance (assumes 80% comfort/confidence level) the market fails us
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What the gamble might buy, and what is at risk…?
Passive represents near certainty of 80% chance of $75,000 income (only
risk is market risk)
Active (with no fees & odds tilted in our favor for our selection discipline) has
about a 25% chance of an extra $21k of income
And a 25% chance of it costing the client $15k of their income
PLUS the 20% chance of the market failing us…
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Sample Payoffs for Sample Client:
= Market 84%Under by 0.2%= 83%Under by 0.5%= 81%Under by 1.1% =74%Over by 1.3%=92%
What is the risk of the Under by 1.1%? (1 in 4?)
What are the odds of the Over by 1.3%? (1 in 4?)
What is risk of being outside of COMFORT with active?50%! (2 in 4 = 50%)
Tell the client 81-84% confidence, but the way you implement the portfolio really makes it a 50% chance of being between 74-92% and a 50% chance OF IT BEING OUTSIDE OF THAT RANGE!
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We measure the confidence of meeting our client’s goals based on the MARKET’S uncertainty
BUTWe completely ignore the UNCERTAINTY of our active IMPLEMENTATION(1 in 3 chance of losing the bet with odds in our favor and NO FEES)
We ignore that active returns will vary from the market average(Just as we used to ignore that market returns will vary from the average)
We misrepresent the client’s confidence & comfort(Tell them 82% confidence based on market returns, then invest in a way that makes that number meaningless…include market uncertainty but evade implementation uncertainty)
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If we are delivering WEALTHCARE…
Isn’t one of the MAIN premises that we will avoid UNNECESSARY RISK?
We accept a RATIONAL amount of risk…»Accept risk that buys us something we value»With fairly high confidence»WITHOUT seeking to avoid all risk (psychotic paranoia…too much sacrifice)
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A Simple Perspective…
If you can confidently achieve your goals with market returns (less nearly certain passive expense…the 84-81% confidence difference at 50 basis pts) leaving you with only one 20% chance of market failing you…
Why would you subject yourself to two 20-28% chances of failing?»One 20% chance the market fails you»PLUS another 28% chance your managers fail you»And the risk is this low ONLY IF….
»The odds really are tilted in my favor»And the additional active expense makes no difference
Which would you pick? Which avoids unnecessary risk? Which has confidence of producing results the client values? Which avoids undue sacrifice to the only life the client has?
True confidence & comfort…the only risk we accept is the uncertainty of the market and we accept this risk to make the most of our life: PASSIVE
Or uncertainty in our confidence, additional risk of failing (28-33%) for a 25% chance of it buying something we value and all of this ONLY IF we CAN tilt the odds and fees do not matter: ACTIVE
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The Passive “Fee Avoidance/Efficient Market/Universe Rank Zealots” arguments are not a reason to invest passively…
The reason we invest passively is to:-Confidently achieve the goals each client values-Without undue sacrifice to their lifestyle-Avoid unnecessary investment risk
So we can DELIVER, making the most of the one life our client has
QUESTIONS?