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You Gotta Look Sharpe

More good than harm flows from academia into the planning arena.

Don Phillips, 02/02/2009

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It's currently quite fashionable to mock quantitative analysis and Wall Street risk models, and no one is sounding this message better or more colorfully than Nassim Nicholas Taleb, author of the bestseller The Black Swan. Ironically, many on Wall Street now use the term "black swan" to describe any event that they couldn't foresee and, hence, can't be blamed for having missed. Of course, that's not even remotely Taleb's point. His point, it seems to me, is that unpredicted events do occur and that one has a responsibility to be prepared.

Clearly, he's right. Investing occurs in the real world, not in a laboratory setting. We can't combine certain securities like chemicals in a test tube and get uniformly consistent outcomes. Too many variables cloud the picture and tamper with the results. The world is messy and often unpredictable. But Taleb doesn't stop with a mere caution about randomness; he urges a virtual overthrow of modern portfolio theory. While there's great wisdom in Taleb's insights, one must ask if it really makes sense to toss out a half century of academic research based on his critique.

Certainly, it's nonsensical to believe blindly in the infallibility of academic models--and it can be suicidal to make leveraged bets on the precision of their conclusions--but that's hardly how most financial advisors that I know use academic research. Advisors have great respect for financial pioneers like Bill Sharpe, but the financial-planning community never really bought into his returns-based style analysis, and no planner that I know would bet the ranch on the infallibility of a Monte Carlo simulation that tells a client they have precisely a 79% chance of meeting their retirement goals.

A healthy dose of common sense permeates the planning community. Planners garner from modern portfolio theory the insight that diversification matters. They take from the Sharpe Ratio the notion that risk is an important part of investment evaluation, not that any one calculation can identify the perfect fund. While their institutional brethren may do some foolish things based on a blind belief in financial theory, I see more good than harm flowing from academia into the planning arena, and I suspect that even advisors who buy into Taleb's worldview won't abandon all the lessons they've taken from academic finance.

When it comes to mutual fund risk evaluation, they'll be making a sound decision. It's easy to decry the limits of mutual fund risk scores, as these are largely relative risk measures and the current market only highlights the benefits of an absolute approach to risk. But most financial advisors handle their clients' absolute risk exposure through asset allocation, not through fund selection. All respected advisors advocate that even their smallest clients set aside six months' to one year's living costs in a money-market account before they even begin to consider investing in equities. Similarly, most advisors suggest cash reserves to cover several years of spending for their retired clients before they begin their allocation between stocks, bonds, and other assets with the remaining savings.

With that framework in mind, it's worth examining the recent results of mutual funds' Morningstar Risk scores. We took the trailing three-year risk score published at the start of 2008 and then calculated the subsequent performance of different levels of risk exposure in various broad asset classes through late October. Here's the chart.

Clearly, the numbers are horrific on an absolute basis, but on a relative basis, the risk scores performed remarkably well. Not only does nearly every risk gradation add value, but the 6- to 12-percentage-point performance advantage between low- and high-risk funds in each category marks a meaningful difference. While losing less may seem like small consolation, remember that you need to climb 100% to recoup a 50% loss, but only 50% to recover from a 33% loss. Sometimes, relative risk matters quite a bit. So, while it's imperative that advisors recognize the limits of all quantitative measures, they shouldn't ignore their potential benefits if incorporated sensibly into portfolio construction.

Don Phillips is Morningstar's managing director, corporate strategy, research, and communications.

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