risk models

The High Tech Rear View Mirror

© Can Stock Photo / canbedone

Once upon a time, we wrote that pretending present and future risk can best be measured by past volatility is akin to driving down the highway with eyes firmly planted on the rear view mirror. (Our theory is the future will not be like the past, so the windshield is a better thing on which to focus.)

The current market upset is the first one featuring the latest generation of so-called risk analytics. These high tech tools generate risk numbers for individual investments as well as entire portfolios. They are entirely based on past volatility. Incorporating frequent updates to the database of past price behavior and enabling near-instantaneous assessments expressed as an index number (say, 1 to 100), they seem quite scientific and highly analytical.

But all of this precision is predicated on the idea that past volatility is a measure of present and future investment risk. So in the latest version, it is like driving down the highway with eyes firmly fixed on an array of rear view mirrors, wide-angle and telephoto and high-definition.

The interesting thing is, when the inevitable downturn occurs, the ‘volatility equals risk’ crowd is quick to point out that their statistical methods are designed to predict what will happen, with a 95% probability. So if you run into a wall while focused on the rear view mirror, there was nothing wrong with the analytics – you just landed in the 5%.

Call us what you want, but a system designed to ferret out risk that fails exactly when you do need it to work may not be all that useful. (An elevator that does not crash to the basement 95% of the time would not be useful, either, in our opinion.)

We will continue to work with our understanding that volatility is a feature of long term investments. It necessitates a long time horizon, so the effect of temporary declines may be mitigated by time. Short term money needs to be kept out of long term investments. And we will keep our eyes focused on the future, not the past.

Clients, if you would like to talk about this or anything else, please email us or call.

Financial Planning and Fortune Tellers

© Can Stock Photo / Anke

We recently reviewed a financial planner’s article about strategies for claiming Social Security. They had software to do a complex analysis. The software required inputs of some raw facts: estimated Social Security benefits at different ages, household cash flow requirements, financial balances.

But the software required inputs, answers to questions about the future:

How much will investments earn in the future?

What will tax rates be in the future?

What will inflation be in the future?

How will household cash flow needs change in the future?

Many software planning tools even ask for the answer to the ultimate question: what will the date on your death certificate be?

The problem is we can’t know the future. So calculating that financial balances would be a tiny amount higher 30 years from now if one course is chosen versus another is probably about as reliable as consulting a fortune teller. Especially when it comes to trying to guess when your retirement will “end”!

But when it comes out of a computer, with charts and graphs and year-by-year tables of numbers, presented by a well-dressed person with initials after their name, it seems real.

At the dawn of the computer age, a phrase was used to describe the analytical version of “you reap what you sow”: “garbage in, garbage out” (or GIGO).1 We might do well to remember it.

Clients, if you would like to puzzle through any financial issue, we would be happy to use real life dialogue to sort out how the alternatives might work out. Email us or call.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.