How much money will I make?

Dubai : What is the most commonly asked question to investment advisers? My money is on the question ‘how much money will I make'. After all, if investing is the process of laying out capital in expectation of a profit; the ‘how much money will I receive back?' style of response is not altogether unreasonable.

Unfortunately, the question ranks up there with the ‘what is the meaning of life' style question. The answer stimulates the academics, and confuses everyone else. Yet it's a question that needs an answer, even though average investors (as well as many professionals) are more likely to find out the meaning of life answer first!

Understanding returns

In underling the difficulty first up, I will bring in William Sharpe's paper titled "Financial Planning in Fantasyland" written in 1997. It is still valid today, as the problem remains unsolved.

He noted: "This sea change in retirement savings is creating an unprecedented need for ordinary human beings to make informed decisions about investing their retirement savings — a task for which most are currently ill-equipped. ....Since such help must be provided at low cost, we are seeing a plethora of computer-based procedures for such financial planning.

One assumes that the approaches typically implemented in such software reflect the traditional practice of human financial planners, but of course it is difficult to know what goes on between two consenting adults when a financial planner meets a client in the privacy of the planner's office".

Sharpe is typical of many a mathematician, wading-in with a boot-in-head attack on financial planners (including the broader universe of banks, investment houses and all sorts of product providers), because the assumptions made in the calculations are fraught with variability, and the greater the variability the greater the inaccuracy. Rubbish in means rubbish out.

William Bernstein is another aggro-mathmetician bludgeoning the usual way investment returns are calculated in his paper "The Retirement Calculator from Hell".

Bernstein fired some of his volleys at the practice of calculating returns with the assumption that returns will go up in a straight line every year, without volatility, or as he said: "Almost all retirement calculations are done with a straightforward amortisation algorithm (via a handheld financial calculator or a software product) that does not take into account the fluctuation in returns. The risk being, if you get a string of bad years at the front end of your retirement, you could run out of money long before the calculated number of years based on an overall rate of return".

The paper produced significant responses and in Paper Three of the same heading, Bernstein eventually concludes that a Calculator War ensued and has finally been won: "The essence of investing is the deferral of current income for future consumption.

"For most people, this means retirement. And in this vein, one important advance has received relatively little attention — the switch from deterministic to probabilistic methods of liability planning.

"There are two ways to perform a probabilistic analysis: the so-called Monte Carlo method, which runs a large number of scenarios containing random variations in input data, and the ‘closed-form' method, which accomplishes the same thing with a single formula.

"The closed-form method, although mathematically more elegant, is not nearly as flashy as Monte Carlo, which can produce psychedelic graphics, beloved by users and journalists alike. It's not surprising, then, that the clunkier Monte Carlo method has won out".

Risk measurements

Whilst we now have a better calculator than we had before we still have the problem of answering the question: what return will I get from a specific or collective set of assets?

Financial advisers will say it's a question of risk. Gordian Gaeta, a locally-based risk management guru, sees the issue slightly differently and more towards an analytical approach.

"The layman and retail investor often confuses opportunity and risk, the risk in entering a casino, might be breaking your leg, an outlier event; whereas across a range of casino players we know that most will lose their money- therefore the risk is breaking the leg, not losing the money!".

Nevertheless, for more experienced investors the answer to ‘what return?' comes from seeking to manage return expectations around volatility. The most commonly used being ‘standard deviation', which is the movement of an asset price around its average price (its mean). Wikipedia describes the SD as "the square root of its variance", more layman-like, "it shows how much variation there is from its mean".

A low SD indicates that the data points tend to be close together (as in a cash asset), whereas a high SD indicates that the data are spread out over a large range of values (like say, the Sensex, or Mena indices).

More professional investors, are likely to use either the Sharpe ratio, which essentially seeks to measure return-risk above the risk free rate (ie the risk premium), or the Sortino Ratio, preferred by the more mathematically inclined because, as Wikipedia says, it is a measure of the "risk adjusted returns that treats risk more realistically than the Sharpe Ratio".

Conclusion

But all I wanted was an approach to assessing risk without being beaten up by mathematicians. To Gaeta for an answer: "One way to tackle the issue is to trust in the fund/asset manager to have learned from their worst scenarios.

"Then if you were to take into account the worst drawdown (biggest loss) over the last three years, and then add-in the funds standard deviation (or Sortino Ratio), then you can work out a downside position for how long it would take you to get your money back — and that method will capture both downside risk and outlier possibilities".

And you wouldn't have got that gem from a financial adviser.

The writer is chairman of Mondial Financial Partners.