Sent: 15-09-2009 10:51:01
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Average Returns and Adviser Qualifications
During the past week I received an email from Professor Sam Savage telling me that he'd finally finished his book "The Flaw of Averages" which is being published by John Wiley & Sons.
I've been following the work of Savage for quite sometime.
In 2000 he published an article in the San Jose Mercury News. His best quote is that, "If you count on the stock market's average return to support you in retirement, you could wind up penniless." You can read that article here: http://www.atcbiz.com.au/r.php?r=2pwhs6r
Averages are used extensively (perhaps even exclusively) in Australian financial planning and elsewhere. I wouldn't be surprised if the use of average returns helped a few investors see the benefits of gearing and retirement strategies which then failed.
In a 2006 Administrative Appeals Tribunal case one financial planner summed up pretty well how planning recommendations are prepared in Australia. He said in verbal evidence that in order to provide advice "a financial planner would calculate that person's taxation and social security entitlements on various sets of options and to (sic) compare the options."
This is not necessarily dealing with the average return issue but with using an almost hit and miss approach to working out the most suitable recommendation to make to a client.
Savage argues that the cure of averages is monte carlo simulation which he says, "generates thousands of scenarios covering all conceivable real world contingencies in proportion to their likelihood".
Monte carlo simulation does indeed seek to do this. However like all modelling approaches it's only as good as the inputs.
A lot of US based financial advisers have used monte carlo for many years but their assumptions didn't cover the possibility of 50% falls in equity markets because such an event was considered beyond the reasonably possible.
Monte carlo is significantly better than average returns but one could argue that there is a good chance it might not be broad enough unless many assumptions are made sufficiently broad. The generation of good random returns is therefore vital to producing good Monte carlo results.
Finally I am indebted to a colleague who last week pointed out some research contacted in the Quantum Financial Services submission to the Parliamentary Joint Committee's on Corporations and Financial Services' inquiry research into financial products and services. Of particular interest is the research about the professional education requirements of various professional activities beginning on page 28 of the submission. Some will see the research and weep. Others will shrug their shoulders and say, "So what?" You can find the document http://www.atcbiz.com.au/r.php?r=s0fc0dm. I would be interested in hearing your thoughts.
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