Robert Boslego: There is no guarantee that stocks will recover from a major loss within the time frame the retirement money is needed. [An investor] may literally die waiting for his or her portfolio to recover.

Why target date funds fail in the one area they're supposed to succeed -- downside protection

SEC recommendations about the inherent risk of target date funds are more controversial than their author's realize, says a veteran risk assessor

July 22, 2013 — 3:40 AM UTC by Guest Columnist Robert Boslego

63 Comments

Brooke’s note: Nutrisystem, based on TV ads, is a very effective way to lose weight. Famously tubby people have paid, cumulatively, hundreds of thousands of dollars to have the little boxes mailed to their houses and lose weight long enough to shoot a commercial. They’re still not exactly slim but back to a mediocre range. So sometimes advice and discipline delivered in a box delivers. The knocks on Nutrisystem relate to the fact that the system’s user may still have several boxes of cookies open in the pantry — or an advertising contract to induce added discipline. There are other issues like the fact that Nutrisystem is more about losing weight and not maintaining weight. Robert Boslego — a Harvard man and graduate of Stanford who has more than 20 years’ experience in developing and providing price risk analysis and hedging strategies for major corporations — seems to have sensed a certain set of related product deficiencies in target date funds. He’s not alone. The SEC has cast a leery eye on TDFs since the ’08 crash and recently offered guidance. All well and good, but the guidelines do not go nearly far enough. And that’s where Boslego comes in.

Target date funds are experiencing rapid growth as baby boomers approach and enter retirement, growing by an average of 30% per year (see Exhibit 1). The target date fund market totaled approximately $485 billion in assets at the end of 2012 and is projected to exceed $1 trillion in four more years.

Usually, one would expect a retail product in a fast-growing, $500 billion market to have a great reputation among the consumers buying the product and the professionals who provide, recommend and sell it. The odd thing here is that its growth may be largely attributable to ignorance. Most owners of the product don’t understand basic, important features of what they own. See: What the alternative is to ill-conceived Target Date Funds.

The Securities and Exchange Commission has been trying to change that. Following larger losses than would be expected of target date funds in 2008, it proposed new rules in 2010 and adopted recommendations of its Investor Advisory Committee in 2013. IThe Commission wants investors to understand the products and their risks.

In this article, I explain how this happened and present the kind of risk analysis I think the SEC wants people to see. I believe that the ultimate solution for investors is risk-managed strategies to fit their circumstances and appetite for risk. See: First, own all the risk.

Default options and the Pension Protection Act of 2006

Behavioral economists have learned two important lessons from researching how people make choices: Never underestimate the power of inertia, and that that power can be harnessed. Research shows that whatever the default choices are, many people will stick with them.

The Pension Protection Act of 2006 was designed to increase saving for retirement by including a powerful default option: automatic enrollment of employees in retirement plans, unless they opt out. Once people are automatically enrolled, a second default option is required: how to invest their money. The Labor Department developed four default options and qualified default investment alternatives were legislated into law in 2007. The most popular QDIA became target date funds, selected by about 70% of employers. See: Experts open playbook on retirement plan reform.

Target date funds are portfolios that are designed to address a variety of risks faced by individuals investing for retirement: investment risk, inflation risk and longevity risk. Balancing these risks involves trade-offs, such as taking on greater investment risk in an effort to increase returns to reduce the chances of outliving one’s retirement savings. The way different financial engineers make these trade-offs can vary greatly, resulting in large differences in risk and return. Many assumptions are needed about a person’s other investments, income, needs and appetite for risk to make such calculations relevant to anyone.

Exhibit 1: Target date fund assets
Exhibit 1: Target date fund assets

Target date funds are designed to become less risky by changing their mix of assets (usually stocks and bonds) as the “target date” (i.e.,. expected retirement date) draws nearer. For example, the fund in Exhibit 2 holds 60% of its investments in stocks at the target date and 40% in bonds. The investment in stocks decreases until 25 years after the target date when it reaches an investment mix with 30% in stocks and 70% in bonds.

The expectation that bond holdings will provide low risk may not prove out. Bond yields have been in a 30-year decline to very low levels and may move higher when the Fed stops buying them to keep yields low. Bond prices fell sharply in May and June at the prospect that the Fed might taper its bond buying later this year. See: Meredith Whitney blames ’60 Minutes’ for her muni 'call,’ then doubles down on the 'hell’ coming for muni bonds.

The shock of 2008

Target date funds suffered significant losses in 2008, and there was a wide variation in returns among funds with the same target date. Investment losses for funds with a target date of 2010 averaged nearly 24% in 2008, ranging between approximately 9% and 41%. The three largest issuers of such funds extended their losses to between 32% and 37% in March 2009, less than 10 months prior to the retirement target date (see Exhibit 3).

The dramatic drop in value of target date funds that were close to reaching their advertised target date brought new attention from the SEC. One study conducted in 2010 found that such funds exposed investors nearing retirement to a significantly higher maximum potential loss than most pension consultants surveyed deemed appropriate. At the same time, almost two-thirds of these pension consultants assumed that they were invested more conservatively than was in fact the case. See: 10 essential steps that 401(k) plan sponsors need to take in 2013 to put clients on the right road to retirement.

Target date fund names and marketing

The SEC staff reviewed a sample of target date fund marketing materials and found that the materials often characterized such funds as offering investors a simple solution for their retirement needs. Even though the marketing materials often included some information about associated risks, they often accompanied this disclosure with slogan-type messages or other catchphrases encouraging investors to conclude that they can simply choose a fund without any need to consider their individual circumstances or monitor the fund over time.

Exhibit 2: Glide path example allocation-based
Exhibit 2: Glide path example allocation-based

In 2010, the SEC proposed a rule that would:

• Require a target date retirement fund that includes the target date in its name to disclose the fund’s asset allocation at the target date immediately adjacent to the first use of the fund’s name in marketing materials.

• Require marketing materials for target date retirement funds to include a table, chart or graph depicting the fund’s asset allocation over time, together with a statement that would highlight the fund’s final asset allocation.

• Require a statement in marketing materials to the effect that a target date retirement fund should not be selected based solely on age or retirement date and is not a guaranteed investment, and that the stated asset allocations may be subject to change.

SEC findings

In 2012, the SEC sponsored a study to assess investors’ understanding of target date funds, which yielded significant findings:

• Only 36% of respondents corrected answered a true-false question asking whether target date funds provide guaranteed income after retirement, the correct answer being that they do not.

• The top reason respondents gave for choosing target date funds was “it seems like a safe investment for retirement.” See: Why the industry needs to accept some blame for 'flaws’ in PBS Frontline’s 'Retirement Gamble’.

When people who own target date funds retire, data show that about 70% of them sell them within three years. For example, Fidelity Investments’ 2010 fund had $11.1 billion in assets as of March 31, 2010, and those assets declined to $5.9 billion as of March 31, 2013. One hypothesis is that retirees soon learn that their target date fund does not provide the guaranteed income many of them expected. And then they see that their principal is exposed to greater risk than they want. See: Fidelity brings its 401(k) muscle to RIAs with new product.

Exhibit 3
Exhibit 3

'Something really important’

On April 11, the SEC Investor Advisory Committee asked the commission to expand its 2010 proposed rule. The SEC adopted its four recommendations:

Recommendation 1
The commission should develop a glide path illustration for target date funds that is based on a standardized measure of fund risk (see Recommendation 2) as either a replacement for or supplement to its proposed asset allocation glide path illustration.

Recommendation 2
The commission should adopt a standard methodology or methodologies to be used in both the risk-based and asset allocation glide path illustrations.

Recommendation 3
The commission should require target date fund prospectuses to disclose and clearly explain the policies and assumptions used to design and manage the target date offerings to attain the target risk level over the life of the fund.

Recommendation 4
The committee strongly supports the commission proposal to require target date fund marketing materials to include a warning that the fund is not guaranteed and that losses are possible, including at or after the target date.

One committee member, James K. Glassman, who is also the founding executive director of the George W. Bush Institute at the new GWB Center in Dallas, was quoted as saying: “We are actually going to teach investors something really important that most of them do not understand.”

Shortcomings in the SEC’s recommendations

The SEC has made no indication regarding the timing for preparing a concrete new rule proposal in response to the committee’s recommendations. As I explain below, this may prove difficult. However, I’d like to contribute some ideas on how this might be done.

I have more than 20 years’ experience in developing and providing price risk analysis and risk management (hedging) strategies for major corporations. I was selected by the former president of the New York Mercantile Exchange to write the chapter on hedging in his book, Energy Futures, for both the 1990 and 2000 editions.

The committee recommended that the risk definition “should focus on factors such as maximum exposure to loss or volatility of returns that are directly relevant to the primary concerns of those approaching retirement.”

The committee’s stated goal is to ensure that the new information that it wants target date funds to provide is an accurate and easily comparable depiction of fund risk, objectively measured, not easily gamed, and sufficiently flexible to apply to different methods of managing risk to allow for continuing innovation among target date funds. See: Dimensional Fund Advisors tells RIAs it’s getting active in its quest for 401(k) assets.

SEC Commissioner Daniel Gallagher has said that the recommendations are noncontroversial. Unfortunately, portfolio risk assessment is a complex subject, and the stated goals are not easily achievable, especially when firms apply different methods of risk management, which can produce very different outcomes. I think this could become quite controversial.

In addition, there is no mention of providing expected returns. On the one hand, I understand why the SEC would not want target date funds to provide that information. On the other hand, how can an investor decide whether the risk is worth taking, or which target date funds offer the best trade-off between risk and return, if all that is provided is risk? Future “maximum exposure to loss” is difficult to predict and would be misleading to investors if larger losses actually occur than are predicted and “volatility of returns” is too abstract and does not tell people approaching retirement how much they can lose.

Risk glide paths

I think a better choice is “maximum likely loss.” This definition would state a maximum likely loss in percentage terms based on a low historical frequency for a specific holding period of the portfolio. It would also include the loss of purchasing power due to inflation. Finally, it would be adjusted to include the fund’s “basis risk,” which is the risk or deviation of its performance versus market benchmarks, based on the fund’s allocations and risk management practices.

The benefit of using historical frequencies is that they are known and are objective measures of gains and losses. The downside is that future risks may be larger than the losses of any past period and may be more frequent.

To provide an example, I based my calculations on annual stock (S&P 500) and bond (10-year Treasury) market returns from 1928 to 2012. I selected a 1% historical frequency of maximum loss for five-year holding periods. See: With inflation on a tear, 401(k) plans look vulnerable and BrightScope publishes a cheat sheet.

I also assumed a 3% annual inflation rate to calculate the loss in purchasing power. My calculations do not include any basis risk, which introduces a lot more complexity to the calculations.

To construct the risk glide paths, I used the stock/bond/cash assets allocations as of March 31 for each of the three largest target date fund groups (Vanguard, Fidelity and T. Rowe Price) for their 2015 through 2045 offerings. I used these as proxies for the change in allocations from less than five years (2015) to less than 35 years (2045) until target dates are reached. See: John Bogle tells the Morningstar crowd just why Vanguard Group has a 'problem’ — and it starts with his dogged criticism.

The maximum likely losses reveal very high potential losses for relatively close target dates, from 34% to 41% for 2015-dated funds, and from 37% to 46% for 2020-dated funds (see Exhibit 4). In addition to the loss of principal, these include an expected loss of purchasing power of 16% (for a five-year holding period) due to inflation.

Exhibit 4
Exhibit 4

Proponents of Modern Portfolio Theory say not to worry about such “paper losses,” keep invested in stocks for the long run. But, as John Maynard Keynes is quoted as saying, “The long run is a misleading guide to current affairs. In the long-run, we’re all dead.” See: Why the Yale endowment model may still be fundamentally flawed.

There is no guarantee that stocks will recover from a major loss within the time frame the retirement money is needed. Consider an investor in Japan in 1989, about to retire. Remaining in equities would have produced a “paper loss” of around 80% over the subsequent 20 years. The investor may literally die waiting for his or her portfolio to recover.

Even as 2013 has been (to date) a breakout year for major stock markets, with the recent rally taking U.S. equities to record highs, UBS group chief executive Sergio Ermotti recently said risk aversion among the bank’s clients is at the highest ever seen in the industry. “Clients’ remain … almost paralyzed, [with a] very high level of cash balances. And this has been the case for the last seven quarters,” he said.

Risk management of target date funds

Investors in target date funds are, in effect, relying on the fund manager’s asset allocation model, which may or may not be appropriate for any particular investor’s situation. The model’s assumptions may be inappropriate — either from the outset or as a result of a change in the investor’s economic or other circumstances, such as job loss, unexpected expenditures that lead to decreased contributions, or serious illness affecting life expectancy.

One alternative is to risk-manage investments in target date funds. Risk management may provide a more appropriate level of risk for any particular investor’s circumstances and appetite for risk.

Taking lower risk is generally expected to produce lower returns. Major corporations hedge their risks because they want to stay in business, and fund their operations and projects. The same logic could apply to individual investors. The often-repeated phase that “market timing doesn’t work” applies to beating market returns. That’s not the goal here.

Effective risk management may, in fact, produce higher returns. That is the nature of risk. Taking higher risks does not necessarily produce higher returns.

For an example, I applied my risk management strategy, vertical risk management, to one target date fund, Fidelity Freedom 2015 (FFVFX), in a back-test from 2003 to 2012. Vertical risk management creates systematic strategies to apply to portfolios. The objective is to reduce maximum losses to more acceptable levels by reducing investment at times in the fund, and then increasing investment. See: Why the Yale endowment model has potentially calamitous pitfalls according to … Yale itself.

The result of applying the strategy to FFVFX was to reduce the maximum drawdown loss from 39% to 8%. Because the strategy avoided a major drawdown (see Exhibit 5), it produced a better total return, up 79% versus 69%. (Important: these are hypothetical results based on a simulation.)

Exhibit 5
Exhibit 5

Conclusions

Target date funds have become a major manager of retirement funds in the United States, and they appear likely to continue growing rapidly, but not necessarily for the right reasons.

The SEC wants to make them more risk-transparent, but that is a tall order because risk is a complex topic. It makes a lot of sense to shift fund descriptions from a retirement date and allocation to a risk profile that includes potential loss estimates, not marketing slogans.

The best way investors can be served is by receiving more customized solutions attuned to their circumstances and risk preferences. I believe that risk management can provide a more satisfactory solution. With Internet services evolving, and Internet- and computer-savvy baby boomers aging, it is becoming possible to reach millions of average investors with more-customized solutions to provide more-satisfying results.

Robert Boslego is managing director of Boslego Risk Services, a consulting firm in Santa Barbara, Calif. He earned a Bachelor of Arts degree cum laude in economics from Harvard College and an MBA from the Stanford University Graduate School of Business. Contact him at Boslego@Boslego.com.


Mentioned in this article:

Boslego Risk Services
Consulting Firm
Top Executive: Robert Boslego



Share your thoughts and opinions with the author or other readers.

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Robert Boslego said:

May 28, 2015 — 1:07 AM UTC

This article was referenced twice by SEC Commissioner Luis A. Aguilar in his speech, “Advocating for Investors Saving for Retirement,” which focused on Target Date Funds, read here: http://www.sec.gov/news/speech/advocating-for-investors-saving-for-retirement.html.

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Elmer Rich III said:

July 26, 2013 — 8:56 PM UTC

This exchange and an article we’re researching/writing on the Biology of Retirement Financial Behavior for The Journal of Retirement – has led us into this world of institutional “risk management.” Interesting, it is clearly a very well developed set of practices. Always fun to learn new technical information.

Now to dig into the research. Stay tuned.

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Brooke Southall said:

July 26, 2013 — 3:25 PM UTC

Elmer,

You’re at your best when you bring in heartfelt thoughts and hard-earned bits of knowledge. Grand statements from the generic dictionary of wisdom, less helpful.

Brooke

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Elmer Rich III said:

July 26, 2013 — 3:08 PM UTC

The most constructive activity for any new idea is hard questions – not flattery. Attempting to censor hard questions is just evasive and defensive. Personal attacks attempting to censor hard questions and cut off debate is unprofessional but the default response.

It is a lot less work to attack the questioner than answer questions. It is also a sales tactic.

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Stephen Winks said:

July 26, 2013 — 2:22 PM UTC

Elmer,

If you can not be constructive in making a point, don’t make the point.

If this sort of nagging and criticism of highly accomplished contributors that actually have something constructive to say is trouibling, to the point that you are detracting from the editorial content here.

No one would be disappointed if Brooke banned you from the site.

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Elmer Rich III said:

July 26, 2013 — 12:31 PM UTC

The point is simple – why should any professional consider the ideas in the article? Where is any proof they are likely to be useful for individual portfolios. All we have is argument by analogy – a program called “risk management” works in the corporate world for one consultant therefore it should (might) work for individual portfolios.

OK, that is the proposition – where is the evidence of it working with individual portfolios? Furthermore, risk management ideas have been around a long time. Surely some academic or professional has tried to make this case prior.

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Robert Boslego said:

July 26, 2013 — 2:29 AM UTC

Thank you, Brian, likewise.

P.S. Since I wrote the article, I felt a responsibility to respond to questions/comments, and a lot of them were very good, and I had fun with a few. My biggest insight from this exchange is that individual clients might benefit from a common corporate view that once objectives are met, they should reduce risk big-time.

Thank you, RIABiz and contributors.

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Brian Murphy said:

July 26, 2013 — 2:10 AM UTC

Elmer,

Do you have an actual job for which you get paid money, or perhaps other interests. It seems you spend a lot of time arguing about things that are at best tangential to the immediate conversation.

Unfortunately for me I initially left the box checked that said “email me if someone responds to my comment”. i won’t make that mistake again.

Be well until next time I comment on an article. Robert, great meeting you.

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Robert Boslego said:

July 26, 2013 — 2:10 AM UTC

Medical treatment is generally agreed upon after many tests (and retests) and testimonials, especially from trusted relatives or friends, and they are both usually very important…not your experience? I’m confused about that subject here.

I think we already agreed that finance and economics is not science like physics or chemistry, and so there are no double-blind tests, etc., of that type to do here.

I only put up my testimonials in response to your comment about how could one person figure out these complex things, etc., and I did, and that is the evidence that I can share by agreement with clients.

I am not here to convince you of anything, but I appreciate your good, probing questions.

I don’t mean to ignore your point about magic bracelets and ghosts, but ….:)

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Elmer Rich III said:

July 26, 2013 — 12:10 AM UTC

So now were into sales tactics. There are numerous testimonials that magic bracelets work and approx 45% of American believe in ghosts.

Independent data is proof. Would anyone get medical treatment based on testimonials or tests?

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Stephen Winks said:

July 25, 2013 — 10:01 PM UTC

Robert Boslego,

WOW !!

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robert boslego said:

July 25, 2013 — 9:43 PM UTC

http://www.boslego.com/Testimonials.html

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Elmer Rich III said:

July 25, 2013 — 9:30 PM UTC

The simple view of applying some version of treasury “risk management” to individual portfolios based on claims of simple analogy to what companies may (theoretically) do is inadequate. The arguments are getting less compelling.

Claiming the loss in personal portfolios is similar to corporate treasury activities managing losses is unproven. The anecdotal, personal experience of one consultant seems insufficient evidence. Some of the terms being similar is a LONG way from credibility.

Then we run again into, what seems the real determinant of portfolio strategies, trading behavior and execution.

This is a very, very, really hard and complex problem. We probably can’t even identify all the variables let alone get them into Excel and a graphing program. The claim of one person, alone, figuring it out is implausible.

But ideas a free and we need a lot of ideas. Lord knows.

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Robert Boslego said:

July 25, 2013 — 7:52 PM UTC

Thank you, Stephen.

The analogy to corporate risk management is that they hedge to protect earnings to fund projects to meet goals. Risk management of investments for individuals to protect investments to fund lifestyle goals is conceptually no different.

With corporate hedging, there is a basis risk. for individual portfolios, it makes more sense just to reduce their size instead of introducing hedging complexities.

One died-in-the-wool MPT wealth manager I spoke with likes the idea of applying risk management to a part of a portfolio, as a way to reduce stress during large drawdowns. Many investors find it difficult to see their portfolios losing large amounts and their advisor doing nothing to stem the outflow.

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Stephen Winks said:

July 25, 2013 — 2:32 PM UTC

Elmer,

Professionals are intellectually curious and find what actually works, sales people just talk about complex problems and offer no substantive solutiuons.

Keep talking, nobody is listening.

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Elmer Rich III said:

July 25, 2013 — 2:25 PM UTC

Professionals think critically about hard problems. Sales people flatter. Ho hum.

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Stephen Winks said:

July 25, 2013 — 2:14 PM UTC

Robert Boslego

Your contribution is the only thing worth while in the entire thread.

I would love to learn more about your work? Is there a copmmercial application that provides signals that would be available on oil, given your hands on experience, that would be far more valuable than a disconnected analyst trying to formualte an opinion.

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804-643-1075

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Elmer Rich III said:

July 25, 2013 — 12:22 PM UTC

That is a fine theory for commercial enterprises in their everyday activities where losses can be made up. It is likely a category mistake to lump commodity trading with long-term portfolio management and protection.

It is not acceptable, and very dangerous, for people’s life savings. The loss of life savings is a societal and governmental crisis – not juts a failure of and economic model. With the recent econ crisis we have seen, however, how dangerous econ models can be – and uninformed about everyday realities – of human behavior.

If supply and demand theories were universal then they should apply to securities markets and individual investing – they don’t.

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robert boslego said:

July 25, 2013 — 2:40 AM UTC

Thank you very much, Stephen. But it’s not a suggestion, I implemented that for over 25 years with many major corporations, mostly in the US, but also worldwide. Most were oil or gas companies, but that extended to major end-users, such as airlines and railroads, etc.

The field of economics/finance is not a science, like physics or chemistry. And yet, there can be a high degree of confidence that some things work and are predictable. Supply, demand as a function of price and income, for example.

We’ve had the Fed buying bonds and that has kept interest rates near zero. By the way, Ben Bernanke was one of the 6 econ majors with me at Winthrop House at Harvard in our tutorial, and we each learned something about supply and demand…even though it’s not science… :)

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Stephen Winks said:

July 25, 2013 — 1:40 AM UTC

Markowitz found Michaud outperformed his conventional optimizer (without Michaud’s MPT enhancements) by 57 basispoints, based on 38 rigorous test to include some with superior information which were peer reviewed and attested by leading academics and practitioners..

I love what Robert Boslego is suggesting as a commodity hedge, reminiscent of the celebrated Victor Sporandeo’s ground breaking work upon which the hedge fund industry is largely built..

Elmer’s point is he would never actually invest in anything entailing risk as performance is not assured to which he equates with science. In that abstract he doesn’t lose money, because he never invests.

While Elmer contemplates the workings of the human mind, he is not adding value for his clients. He does not understand he must take a position which invariably entails risk as there are no guarantees. What does this tell us about Elmer ?

We are dealing with an amature with no experience. There is no common sense as a reference point. By never taking a position entailing risk Elmer deems investing is not a science thus there is no professional accomplishment that would lend credence to his claims of professional standing.

What a waste of time.

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Robert Boslego said:

July 24, 2013 — 10:53 PM UTC

What has worked well with corporate clients for hedging their energy price risks is to project their future income based on oil futures prices (once I develop such a model for them) because future earnings can be hedged in the NYMEX futures markets. They decide in advance how much they want to hedge, based on their risk preferences and future earnings projections.

This approach was independently evaluated by many clients, and a few testimonials are listed here: http://www.boslego.com/Testimonials.html

My approach for risk-managing investment portfolios is described in this presentation:
http://www.boslego.com/Resources.html

I cannot promise future performance, and it’s illegal anyway. I understand that this is not physics or chemistry and market assessments is not a science. It’s a more of a question of what makes the most sense.

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Elmer Rich III said:

July 24, 2013 — 6:59 PM UTC

So how can an approach like this be independently evaluated. GIPS?

How can losses be managed?

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Robert Boslego said:

July 24, 2013 — 6:43 PM UTC

Robert Michaud MPT Optimization

The origins of this strategy are detailed in his book, “Efficient Investment Management,” first published by Harvard Business Press in 1989. His research led to the 1999 launch of New Frontier Advisors. Its managers run portfolios using a novel optimization strategy Michaud and his son, Robert Michaud, developed called “Resampled Efficiency.”

At its core, this resampling technique allows optimizers to consider and incorporate the possibility that the statistical inputs entered into an optimization model are wrong. Simply put, resampling allows managers to assign a greater range of probabilities to various outcomes.

The firm tends to make a bulk of its changes at the beginning of the year. It monitors portfolios each month, and usually by midyear, a few other changes are required, Michaud said. “The portfolios don’t get turned over completely almost ever,” he added. “Tweaks are made from time to time, but this is a low-turnover strategy.”

Source: http://www.indexuniverse.com/sections/features/5810-michaud.html?fullart=1&start=2

What this says to me is that Michaud isn’t managing risk. I don’t think it makes sense to invest money without a risk management strategy for containing maximum loss, at which point measures are taken to reduce the potential for greater losses.

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Elmer Rich III said:

July 24, 2013 — 5:11 PM UTC

Think of it this way. Ben Graham is held up as an authority. Has our knowledge of economic behavior not advanced dramatically since 1934? All other areas of human knowledge have.

Imagine a doctor, engineer, physicist or any other professional stuck with ideas and practices from 1934! But his book and ideas are treated more with the reverence given to religious texts than evidence-based theories. His book is almost literally the “Bible” of the value investor. A recent peer-reviewed paper we recently were given as justification for the new DFA value calculations spent much of the beginning claiming adherence to B Graham’s models.

In 1934, B. Graham’s ideas were no doubt more disciplined than others. That is not true almost 80 years later.

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Elmer Rich III said:

July 24, 2013 — 5:03 PM UTC

We don’t respond to hostile personal attacks.

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Stephen Winks said:

July 24, 2013 — 4:45 PM UTC

Elmer,

You cannot be serious. Your are deceiving yourself. Even in this space we have repetedly illustrated the error of your thinking. Would any professional or lay person entrust you with their money or practice when you can’t tell the difference between an Ugandan witch doctor and a prudent expert?

So, Markowitz doesn’t know a thing and you are the only person in the world that that can act in the consumer’s best interest, right ? How absurd !

I have never seen the vanity, the absence of humility, or an ego quite as large as yours, with out any accomplishment to base it on..

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Stephen Winks said:

July 24, 2013 — 2:58 PM UTC

Robert Boslego

You description of retail optimizers is absolutely correct:

“, so we push down the estimated return of European stocks or add a constraint that limits European stocks to 10 percent of portfolios. We give the optimizer another spin and get another efficient frontier. We continue spinning until we get an efficient frontier with portfolios that really appeal to us, the ones we wanted all along. The result is that we can now pretend that we have found them on the “scientific” efficient frontier.”

Dick Micheau, would agree. Dick is acknowledged by Markowitz for creating the best approach to global strategic asset allocation existant. This was achieved by Michaud’s five patentented, peer reviewed and proven (by Markowtiz himself in 38 rigorous tests) innovations to MPT.

Retail optimizers are manipulated to the point of not being effective. Michaud proved that a superior optimized beats superior data—to the suprise of everyone to include Markowitz. A perfect illustration of science outdating theory.

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Elmer Rich III said:

July 24, 2013 — 2:35 PM UTC

In our professional capacities we now have the tools to see inside of a brain and measure the physiological changes that occur when behaviors, that we in our culture label as “trust”, occur. So we have measurable physiological phenomena that we can use to predict behavior we call “trust” in the future.

But more practically we don’t need to use brain scans. We can then also generalize across groups of people using “Big Data,” similar to Nate Silver’s predictions of the elections, and look at what people do rather than what they say — to make predictions about behaviors of individuals and groups of people.

Like we no longer allow doctors to treat patients using common sense or engineers to build airplanes based solely on their intuition of the moment – so it is best to be suspect of common sense without proof to back it up. For example, research shows doctors using their uncommon sense are far less accurate than a simple checklist.

Yes, our brains and our behaviors developed far more to be good subsistence farmers than investors and handle technical long-term matters.

BTW, these are not “my” ideas. I simply report what me and my team have learned from studying primary research that may help investors, especially retirement investors, build and protect their life savings.

We are marketers looking for things that will work today to help clients help their clients.- not scientists. For the first time, this information is now freely available to everyone. We just share what we learn.

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Stephen Winks said:

July 24, 2013 — 2:07 PM UTC

So, Elmer,

Because Trust is not measurable and predictive it doesn’t exist ????

I think you have forgotten about a thing called common sense, a trait that primative famer’s in the field in remote lands know far more about than you portray.

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Elmer Rich III said:

July 24, 2013 — 1:03 PM UTC

Exactly, econ is more of a humanities subject. An important approach to new knowledge but descriptive and not predictive.

The requirement of a science is that it predict measurable events in the future. Now the measurement can be a discreet or continuos dependent variable. But the independent variables must contribute to the accuracy, within an error terms of that dependent variable measurable prediction.

It appears that only with, mainly, double-blind experimental procedures can that kind of accuracy. So Einstein’s original theories were untestable at the time but he made specific predictions. Only in the last 2 years have we had the tools to make the measurements and they have turned out to be accurate within .00000000x or something similar.

He could do that because the math modeling of physical events is very accurate.

Another characteristic of modern science is that progress is generally being made by bigger and bigger groups of people. Groups that constantly exchange, argue and share openly information and data. There is research that the more openly a scientist shares their data, the more professionally successful and experimentally successful they are. This openness and transparency seems a requirement.

Of course, that is anathema to business and industry. Brain research and biological research on behavior is also like this – an area we have studied for years.

So what do we do in financial services? Well, first we accept the truth. We have no choice the truth is now public. Our models are analogical and not predictive. They just aren’t.

Will they ever be predictive? Not in our life times or maybe many lifetimes after us. We just don’t have the methods or perhaps even the data yet. I believe we start with animal behavior and the brain “bottom up” but that is a radical idea, although the science is airtight and very predictive. Econ behavior is, after all, first the exchange behavior of discreet individuals.
Since it is a biological mechanism the processes and medical facts are universal – even across species.

Current econ and finance models are “top down” they start with popular intuitive “higher order concepts” of how the world works and try to prove them out – or do back testing/curve fitting. That’s where the money and demand is – so the supply conforms. But just meeting demand will always hinder discovery of new facts.

By definition, there can be no demand for what is not yet known. But the problems we need to solve demand predictive knowledge we don’t yet have.

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Robert Boslego said:

July 24, 2013 — 2:48 AM UTC

My diploma from Harvard says I have a degree of Bachelor of Arts cum laude in Economics…not a Bachelor of Science. I don’t think they confuse economics or psychology with physics or chemistry.

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Elmer Rich III said:

July 24, 2013 — 2:45 AM UTC

It is a marketing implied misrepresentation that should be owned up to now that it is easy to get public knowledge. As an alum of University of Chicago, I contacted them when I found out. As expected, denial was their response. I suppose they believe they can keep it a secret.

It’s a silly pretense for the profession. May it RIP.

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Elmer Rich III said:

July 24, 2013 — 2:34 AM UTC

Right, so economics does not meet the standards of evidence necessary for a true science. That is fine.

However, now the weakness of the evidence for these theories is fully available to everyone.
I directed to and read a paper claimed as the basis for the new value tilt being promoted by Dimensional Fund Advisors. I am used to studying neuroscience and biology primary research.

The public claims of DFA and others adopting this new value metric are simply not supported. Glad to provide further details. Again, OK. The study of economics is largely an “analogical”, and not scientific, body of knowledge – as claimed by a chief EU economist well funded by corporations. OK, again.

However, when we move into the arena of investing people’s life savings – as a social necessity we must demand real evidence. DFA has a short video touting their “evidence-based” methodology. It is just a new marketing buzz word. We’re marketers we know.

If we can see the holes in academic research so can a plaintiffs attorney who will claim the asset management marketer/ing was either lying, misrepresenting or incompetent in their business representations to his (class of) clients. Same with regulators.

You simply cannot say the things that the industry used to, and still does, anymore. This is a structural fact and not a personal opinion.

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Robert Boslego said:

July 24, 2013 — 2:25 AM UTC

Elmer,

Do they have to give the prize money back if the theory upon which it was won was disproven, or shown it is not useful?

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Robert Boslego said:

July 24, 2013 — 12:26 AM UTC

Confirmed: Not a Nobel Prize

The Prize in Economic Sciences is not a Nobel Prize. In 1968, Sveriges Riksbank (Sweden’s central bank) instituted “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”, and it has since been awarded by the Royal Swedish Academy of Sciences according to the same principles as for the Nobel Prizes that have been awarded since 1901. The first Prize in Economic Sciences was awarded to Ragnar Frisch and Jan Tinbergen in 1969.

“Nomination and Selection of Laureates in Economic Sciences”. Nobelprize.org. Nobel Media AB 2013. Web. 23 Jul 2013. <http: www.nobelprize.org="" nomination="" economic-sciences=""/>

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Elmer Rich III said:

July 23, 2013 — 11:31 PM UTC

Right, but all financial and econ modeling suffers from the same lack of true experimental theory testing.

Since econ and finance theories and knowledge is not empirical but driven by classical (centuries old) beliefs about human behavior – there is no way to test them using accepted scientific standards.

However, all animals have economic behavior. Exchange of resources is the basis of life and the principals were solved in other animals long before humans came along. Economics is fundamental just the biology of “getting” behavior. That is real science but will only be fought by econs.

BTW, the “Nobel Prize” in economics is not awarded by the real Nobel Committee and does not meet the evidence standards of the other real prizes. It is awarded by the economists of the Swedish Central bank and merely co-branded with the real Nobel Prizes.

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Robert Boslego said:

July 23, 2013 — 11:13 PM UTC

correction: Loring Ward

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Robert Boslego said:

July 23, 2013 — 11:11 PM UTC

Modern Portfolio Theory was mentioned a few comments back. MPT is implemented through the mean-variance optimization process (“MVO”). According to David Swensen, Chief Investment Officer of the Yale endowment:

“Unfortunately, the mean-variance optimization process provides little useful guidance in choosing a portfolio.”

Source: David Swensen, Pioneering Portfolio Management, page 123.

——————————————————————————————————————————————————————————————

In a recent article, the CIO of Ward Loring wrote:

“The usual application of the mean-variance optimizer is a charade, “an absurd pretense intended to create a pleasant or respectable appearance,” according to OxfordDictionaries.com. Charades are fun, but they are not funny when we are blind to their pretense.

“Here is how the charade is played within the context of portfolio theory. We assemble estimates of parameters for the mean-variance optimizer: expected returns, standard deviations, and correlations. We assemble the estimates from historical returns or from seemingly sophisticated methods, such as those invoking Bayes theorem or “resampling.” We place the estimated parameters in the mean-variance optimizer and give it a spin. Out comes an efficient frontier with portfolios such as the one with 70 percent in European stocks and 30 percent in gold. We find this portfolio unappealing, so we push down the estimated return of European stocks or add a constraint that limits European stocks to 10 percent of portfolios. We give the optimizer another spin and get another efficient frontier. We continue spinning until we get an efficient frontier with portfolios that really appeal to us, the ones we wanted all along. The result is that we can now pretend that we have found them on the “scientific” efficient frontier.

“It is time to end the charade.”

http://www.fpanet.org/journal/EndtheCharade/

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Stephen Winks said:

July 23, 2013 — 6:01 PM UTC

Elmer,

By your definition of science, brain surgery is complex and not certain, so it is not science.

I think everyone familiar with your logic get the picture. You are clueless.

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Elmer Rich III said:

July 23, 2013 — 5:41 PM UTC

With the hyper-transparecy of the web, the immediate access to primary economic research (and all others) and the growing dominance 0f people’s life savings as the assets in the industry we are all forced to be held accountable for claims and statements of fact.

This is a new structural reality forced on everyone. In the past, the evidence, data and research was “locked up” in academic journals and paper documents – no more. Everything is now digitized. So the standards of proof have jumped significantly.

Of course, old theories, ideas and practices will not stand up to the new scrutiny.

Expert, professional knowledge, research and work is very hard, takes a long, long time and is generally not well paid since it is very uncertain and the pay offs come in decades.

But old ideas give way to new and more accurate ones. That has always been true. Why fight the natural process of learning new and better ideas and which old ones to discard?

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Stephen Winks said:

July 23, 2013 — 5:28 PM UTC

Elmer,

So, you prefer the Ugandan witch doctor, not being able to discern the difference?

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Elmer Rich III said:

July 23, 2013 — 5:23 PM UTC

Attorneys and plan sponsor experts have told me that the “prudent man” need not be an expert and is not held to those standards.

Thus, acting as peers in similar roles constitutes fulfillment of the standard. Not perfect, of course. But it appears that the, maybe back to common law, proscriptions are following the idea of a “jury of one’s peers” expanded into a “trust” relationship.

Facts, evidence-based knowledge and science is, by definition, independent of local, individual and temporary circumstances. The laws and proven models of gravity, biology, engineering, medicine are not dependent on their application. If the execution of MPT determined it’s predictive usefulness, then MPT is merely a hypothetical model with little value – which may be true.

Finally, if any or all of these theories worked, professional investors wouldn’t need outside money, of course.

As in all professional discussions, we are discussing ideas here – not personalities.

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Stephen Winks said:

July 23, 2013 — 5:10 PM UTC

Elmer,

The average reasonable man is different from a prudent expert in that it incorporates a more indepth understanding. Prudent experts have professional standing.

With whom would you entrust you money?

If you are to use the reasonable man standard in Uganda, a witch doctor will do. If you are a soverign wealth fund subject to the highest level of discernment, you would prefer a prudent expert. as judgement is required far beyond the average reasonable man. This requires training and at least the acknowledgement of ongoing fiduciary duty. This distinction is not embraced in the retail market but is in the institutional markets.

For example, Modern Portfolio Theory and optimizers are based on the historical performance characteristics of asset classes but when current market conditions contradict historical precedent, optimizers lose their relevence. Not because MPT does not work but because MPT is not effectively executed. During periods like today where current market conditions contradict historical precedence, more informed views shaping capital market assumptions are required which materially impact asset allocation and portfolio construction. This is why retail optimizers do not work as they never go beyond historical performance of asset classes. Access to this type of advanced statistics and daunting mathmatical resources are not available in the retail market but it is for trillions in the Sovereign Wealth space. This the type of world class support brokers is what brokers should be giving up 60% of their gross revenues for, it is just culturally not possible in a brokerage format because fiduciary duty and liability is entailed.

This doesn’t have to be the case, as this intellectual capital can be easily brought to the retail space.

This instititional bias counter to the best interet of the investing public has crippled the brokerage industry in serving the best interests of the investing public, to which Elmer applauds.

Elmer, do we have to belabor every point—you are not looking very good in all of this, but please continue.

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Ron Surz said:

July 23, 2013 — 4:12 PM UTC

Where’s the regulatory language that says “Choose T. Rowe, Fidelity or Vanguard?”

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Elmer Rich III said:

July 23, 2013 — 3:44 PM UTC

Wait. So the supposed PDF posting of DOL language is just a personal opinion and POV piece. Where is independent regulatory language supporting the claims about fiduciary responsibility?

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Elmer Rich III said:

July 23, 2013 — 3:40 PM UTC

OK, how is a plan sponsor to become an “expert” in economics and portfolio theory? Even “expert” claims rarely follow real science and evidence as we are learning.

Give the increased speed and complexity of retirement and investment markets, even academics who make their livings studying these things have been caught well behind the rush of events.

Again, fear-mongering deflects real problem solving.

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Stephen Winks said:

July 23, 2013 — 3:18 PM UTC

The consumer is the arbiter. They trust that their broker is doing the right thing and don’t understand the broker “is doing the best they can” not knowing that it is counter to the best interest of the investing public—certainly legal but unethical. Dodd-Frank makes unethical behavior to retail investors, illegal, as it is now for all other investors.

Elmer is having difficulty reasoning professional standing because it is different from what brokers are doing under a suitability standard. Yet advisors who act in a fiduciary fiduciary capacity achieve professional standing and have won and deserve the trust and confidence of the investing public. The reason why advisors are rapidily growing market share is advisors are actually acting in the client’s best interests—they are literally doing the right thing.

Industry apologist can not reconcile that retail investors are afforded lesser consumer protections than all other investors contrary to equal protection under the law assured by the Constitution. This is the intended outcome of the powerful brokerage industry lobby which indisputably acts counter to the best interests of the investing public.

There are no unintended consequences with Dodd-Frank, the intention is having the consumer’s best interest comming before that of the brokerage industry as the consumer expects as required by fair dealing..

Elmer, as a self professed ethicist and industry apolgist, believes “who cares” about public trust and inconvenient truths like the US Constitution and those pesky statutory requirements for those that serve in a position of trust in handling the funds and investments of investors who have limited investment knowledge and experience. The consumer is counting on us to do the right thing. If that trust and confidence is lost and professional standing is dismissed, the financial services industry will have failed the investing public.

The industry is engaging in self-destruction, while Elmer cheers along..

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Ron Surz said:

July 23, 2013 — 2:37 PM UTC

Your understanding is wrong. Fiduciaries are not protected by the lemming rule. Please see http://www.targetdatesolutions.com/articles/DOL-Release-201302.pdf

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Elmer Rich III said:

July 23, 2013 — 1:40 PM UTC

My understanding is that fiduciary duty is following the practices of one’s professional peers and “prudent men” not prudent “experts.”

There is no requirement for a plan sponsor to be expert in the arcane technicalities of economics and finance theory. That would be impossible anyway.

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Ron Surz said:

July 23, 2013 — 1:29 PM UTC

Target date funds are selected by fiduciaries, primarily advisers, who have a duty to understand and vet. They are breaching their fiduciary responsibility, but feel safe because everyone is doing the same lax job.

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Elmer Rich III said:

July 23, 2013 — 12:33 PM UTC

How are investors and consumer ever going to have enough information to make intelligent demands let alone decision? These are critical matters – not consumer goods like an iPhone or amenable to political slogans.

The suggestion would be equivalent to consumers being their own doctors. Investment, and medical, matters are getting much more complicated and much less comprehensible to a lone consumer-investor. Larger and larger teams of specialists are now the norm in other professions – the opposite of “do-it-yourself.”

Just because much more information in available on the web does not mean it is appropriate for decision or more useful.

Idealistic hopes are best not useful for the hard realities of protecting people’s life savings.

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Robert Boslego said:

July 23, 2013 — 6:37 AM UTC

Thank you, Brian.

I agree that consumers, the public, ultimately can and do bring change that even the most powerful governments and firms can’t control. What people need is good information. The average person is not stupid, though that is how people are often treated by governments and corporations.

I really like your reference to Steve Jobs/Apple to think differently. It reminds me of the Robert Kennedy quote that “some men see things as they are and say ‘ why.’ I dream things that never were and say ‘why not.’?

We don’t have to be powerless.

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Brian Murphy said:

July 23, 2013 — 5:59 AM UTC

Great article, Robert. My belief is that things won’t change until consumers themselves force a change based on the advent of a better retirement model. True change won’t come by way of regulation. That’s the way the world works and I applaud all those like yourself and Ron putting forth the effort to “think differently”.

We believe there will be a better model, and at Kivalia we’re working on it ourselves. Why not build an interactive “drawdown” model that captures all this right on a website – and maybe build overlay strategies to manage that risk for employees…hmm. Just thinking out loud. It’s not like someone could actually do that now – is it?

Robert, I’ll try to reach out directly. Thanks.

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Robert Boslego said:

July 23, 2013 — 2:04 AM UTC

I would like to be more pro-active and help average investors understand their risks to make informed decisions. Boomers are internet savvy and that doesn’t have to happen.

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Ron Surz said:

July 23, 2013 — 12:17 AM UTC

It will take lawsuits, rather than the SEC, to get the attention of fiduciaries, which will likely happen when the next 2008 occurs. In the meantime, the Big 3 will pocket an obscene amount of profit. They control 80% of the assets.

The sort of good news is that class action lawsuits will restore some of the losses the poor beneficiaries will sustain in this next disaster. Fiduciaries should know better. TDFs are the other 401(k) scandal, exacerbating the excessive fee problem. Fiduciaries are complicit in these scandals because TDFs are employer-directed rather than participant-directed.

Is anyone listening?

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Robert Boslego said:

July 22, 2013 — 11:42 PM UTC

Yes, VRM can be applied all along the Glide Path. It’s an approach of trying to keep losses within a tolerable range.

Risk management is all about setting goals and trying to manage risks so that the goals can be achieved. All investment strategies involving risky financial assets are essentially risk management strategies.

MPT, by design, is essentially a fixed plan. It does not manage risk.

I suspect that if people were asked, most would agree with Ron that their risk tolerances approach 0% as the target date approaches. If TDFs could lose 35% within 5 years of the retirement date, as the analysis above indicates, this a serious issue. Everyone invested in these TDFs needs to know this, so that they can make a wise decision.

That’s what I think the SEC intends to do. It’s just not going to be easy to get hard numbers for the risk of loss.

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Ron Surz said:

July 22, 2013 — 10:46 PM UTC

Thanks Steve Winks for your kind words. My efforts have been focused on risk at the target date, whereas it looks like VRM can be applied across the entire glide path. I think risk at the target date is of critical importantance because it’s when lifestyles are at stake. Account balances are at their highest level and there are no second chances. There’s a risk zone spanning the 5 years before & after retirement that make or break lifestyle plans. The critical fact is that most withdraw their savings at the target date, so it’s game over — no “through” funds ever make it to their intended end.

Check out the joint SEC-Dol June 2009 all-day hearing on target date funds. It was entirely about 2010 funds — funds near their target date. Can you guess why?

If VRM can make life better at longer dates, bravo. I’ll stick to my story that no risk — zero — is the only correct risk at the target date.

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Robert Boslego said:

July 22, 2013 — 9:58 PM UTC

Alex,

In the example using FFVFX, I am taking the same or less risk as an unmanaged position in FFVFX. Again, this is a back-test of a risk management methodology.

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Elmer Rich III said:

July 22, 2013 — 9:18 PM UTC

We have been making an effort to replace the use of the term “risk” (a known probability of an outcome) with what is accurate or “uncertainty” (unknown probability of outcome). The MIT economist Albert Lo pointed this out years ago.

We have also been pointing out that what is called “evidence-based” in financial services is not. It is theories but there is no double-blind, experimental evidence or data proving these claims. Back-testing is not “evidence” nor are other forms of curve-fitting modeling. The use of the terms “evidence-based” has become a new marketing buzzword – but it has detailed requirements.

Further, the behavioral models and theories also questionable. We are submitting a paper to the Journal of Retirement on the evidence here.

Once we accept that we are talking about true uncertainty – then better models, theories and experimental testing can move ahead. However, uncertainty may not be manageable in financial markets – by definition.

Promising is the discovery in other professions that human behavior is flawed, unreliable and often harmful – at whatever level of expertise. Thus, computers diagnose better than doctors.
But in econ and financial services we are handicapped by:

1. The theoretical and untested nature of the knowledge
2. The flaws in humans building the computer programs

Again the expanding speed, complexity and uncertainty of investing may not be manageable. Nothing says it must be so.

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Robert Boslego said:

July 22, 2013 — 5:41 PM UTC

The SEC wants people to know their maximum risk exposure in Target Date Funds, especially as they approach retirement. As it turns out, that is not so easy to do. It requires a methodology all TDFs would adapt to calculate Risk Glide Paths. Mine is an objective approach based on historical data. As I say, we don’t know what future risks will be.

The SEC did not see this as controversial, but I think it will be. A lot of assumptions are required in any approach for calculating future risk.

My solution is a risk management strategy where the exposure is decreased when risks rise. I call it Vertical Risk Management. Many corporate clients want to hedge when risks are high, and reduce hedges at other times. This is what I have developed for investment portfolios and can customize it to fit different risk appetites.

VRM is an evidence-based strategy that is designed to overcome behavioral biases through the structuring of rational decisions in advance, under non-crisis conditions. VRM is based on the view that the future is unpredictable. What it does is react to price events in a rational, consistent way, to control risk.

Three theories upon which VRM is based are:
Price-to-Price Feedback
Volatility Feedback
Prospect Theory/Disposition Effect

Price-to-price feedback is explained by Yale Professor Robert Shiller in his paper, From Efficient Markets Theory to Behavioral Finance. ( http://www.econ.yale.edu/~shiller/pubs/p1055.pdf) :

“Faith in the efficient market theory was eroded by a succession of discoveries of anomalies, and of evidence of excessive volatility of returns…Some important developments in the 1990s and recently include feedback theories, models of the interaction of smart money with ordinary investors, and evidence on obstacles to smart money.”

The overall idea is to have a systematic strategy for hedging risk that is well-thought out to avoid the behavioral problems associated with making decisions during a crisis. Anyone wishing to view a presentation of VRM can see it at the bottom of this page (http://www.boslego.com/Resources.html).

I didn’t describe it in the article because the article was intended to discuss the risk methodology and results.

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Stephen Winks said:

July 22, 2013 — 5:13 PM UTC

Ron Surz is widely acknowledged as the industry’s top expert on Target Date Funds, known for his highly lucid, widely read primary research in TDFs.

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Joe Gordon said:

July 22, 2013 — 4:44 PM UTC

Agree with Alex…and even add: so many so critcal of TDFs are simply talking their book…agree they are not perfect but what is except a guaranteed annuity which is guaranteed to not hedge inflation, if we ever have it again, and guaranteed to conficate your capital at death.

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Alex Potts said:

July 22, 2013 — 4:32 PM UTC

Could you please define for the readers what “vertical risk management” is? Without understanding what risks YOU are taking, this article is useless and merely comes across as simply an ad for “black box” management.
Thank you.
-Alex


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