U.S. Competitiveness Should Be Dodd-Frank Priority: Industry

[Stephen Winks]

It is interesting that the US is still the leader in global finance, except not in the US.


How can young Chinese PhDs steeped in modern portfolio theory out execute Americans in global portfolio optimization using US intellectual capital?



There is no willingness on the part of massive US financial institutions to question todays ill conceived and poorly executed optimizers or even consider patented and proven innovations in optimization. As Thomas Friedman observes in his upcomming book, "That Used to be US", the world is becomming flat because of connectivity. Commodity services are loosing considerable value where services requiring intellectual capital, skill and creativity are becoming far more valuable. It is no longer acceptable to be average, only outstanding will do.



We are loosing our place in the world of finance by actively dumbing down the delivery of advisory services rather than pushing the limit of innovation and science. If there is a patented and provable approach to portfolio optrimization/construction resulting in a significant competitive advantage and the industry is not actively seeking it out like the Chinese, we only have ourselves to blame.



The same is true of prudent process authenticated by statutory documentation which makes advice safe, advanced technology which supports fiduciary standing, work flow management tied to a functional division of labor which makes expert fiduciary counsel scalable and easy to execute, conflict of interest management, not just disclosure which perpetuates conflicts, expert advisory services support for each of te ten major market segments advisers serve.



Never in the history of man has the consumer's best interest not prevailed in a free market. The industry has openly pushed back on the fiduciary standing of brokers and insurance agents. The industry has lost its ability to lead by placing its interest ahead of that of the consumer--the literal definition of fiduciary duty. It is not the adviser. It is a matter of vision and leadership, the ability to do more with less in new ways that used to be the hallmark of US innovation that changed the world.



John Taft and the SIFMA can be a catalyst for innovation or can cripple the industry by preserving status quo of an outdated business model? Which will it be? There is encouragement with the new SIFMA proposal to the SEC on the fiduciary standing of brokers. As Harvard's Clayton Christensen (Innovator's Dilemma) observes, the biggest mistake industries make when looking at induastry redefining innovation is looking at innovation in the context of its existing business model when a new business model is in order. If the US is to lead, there are a lot of changes afoot and the Chinese are not waiting for permission to execute and strangely have clarity in free enterprise and aligning with the best interest of the consumer that we have forgotten.



Wouldn't it be a good idea to align with the best interest of the consumer rather than asking how do we subvert fiduciary standing? Where is the leadership critical to maintain our standing in the world?



SCW

[the observer]

Dear John and Bradly,

Problem apparently solved

Please chip in one third each with me for a one-way ticket to China!

[Lucullus]

Observer,

What have the Chinese done to you to deserve that?

[Bradly T.]

You know how important consumer's best interest is to the Chinese communists!! Let's hope one of us moves...soon.

[Stephen Winks]

Lucullus and the observer,

Just stating the facts boys.

When bright young (younger than me at 60 something) Chinese PhDs go in depth on Optimization citing the limitations of Black/Litterman and the superiority of Michaud's mean variance optimization and resampled efficient frontier, it shows initiative and intellectual curiousity found lacking in todays generation of investment professionals, such as yourselves.

By our disinterest in innovation, and lais-sez-faire attitude toward professional standing, we are ceeding market leadership to the Chinese.

I realize you boys could care less, but some of us do and hate to see America's standing in global finance deteriorate.





I would suggest you refamilarize yourselves with Hong Kong, perhaps one of the most dynamic capital markets in the world.


SCW

[Lucullus]

On the other hand, Observer, you may have a good idea there. Count me in for a third.

Coach, of course. And One Way.

[the observer]

Hi John & Bradly,

When the Chines PhD visits 55 year old Joe Schmoe average American and calculates he needs $1.5 million by age 65 to maintain his standard of living through Age 90 and he contemplates the 50K in his IRA with no pension plan finally coming to the realization that he's going to die with a wrench in his hand working because he's been screwed by politicians all his life and won't be getting his social security check, let alone medicare... I personally think he's going to say you can take your "limitations of Black/Litterman and the superiority of Michaud's mean variance optimization" and shove 'em up yer jacksey... Assuming he takes the meeting with the chines Phd in the first place of course...

Come on Brad... put up a third!!

[Bradly T.]

I guess what we need then is legislation requiring improved optimization and retirees will suddenly be saved from lack of thrift and debt carried into retirement. I hope Uncle Sam improves his optimization too.....the Chinese already own his you know what. I'm down for a third.....anytime. I love this "never in the history of man....." line - if you just repeat the same lie often enough, someone will believe it......if only the fool saying it evidently.

[the observer]

All this jibber jabber is much like the Monte Carlo fanatics of old. For the average American and the statistical average savings of the average American you can take a perfunctory look and pretty much know at once the money's going to run out before they die... unless they stop taking their meds and increase their caloric intake by a factor of 8 to decrease their life expectancy.

[Bradly T.]

Agreed....you cannot technically correct fundamental flaws and poor strategies any more than one can "simulate" future outcomes OR their true probabilities.....has some value in the law of large numbers perhaps, but not for any individual. One cannot remove the humanity from the equation as enticing as that may be and it's the human nature that will ultimately determine outcomes for all. Ahhhhh, the true value of personalized financial planning has NO substitute in policy, optimization, or Monte Carlo.

[Lucullus]

In a presentation I gave at the FPA national conference in Boston (2006), I spoke about what we, as financial advisors, do.

"So what are we actually doing when we fire up our software and proceed to build our clients' porfolios, smack dab on the efficient frontier?

I suggest that what we're doing amounts to this: Our client has handed us the keys to his car and is buckled up in the front passenger seat. We get in the driver's seat, buckle up, and proceed to drive that car down a highway at 70 miles per hour, on a moonless night, with the headlights off. And where are our eyes focused? What are we looking at?

The rear view mirror. Because that's all we've got.

How many of you find that image profoundly disturbing?"

Lots of raised hands.

"Ok. I, too, find it very disturbing and downright scary. But let me ask you this: How much more disturbing would it be, how much scarier would it be............. if we had our eyes closed?

The rear view mirror of history isn't a crystal ball. Or a windshield to the future. But it's a lot better than nothing."

[Stephen Winks]

Lucullus,


Pretty sad, if that is your understanding of optimization.



This is 2011, not 1952.



SCW

[Bradly T.]

I do believe that the rear view mirror has value for future planning IF one understands what they're looking at behind them. It is not a comforting or particularly predictive view to be sure, but provides perspective nontheless. There are certainties in the future that are constants from our past - natural forces and laws of interaction and reaction which do not fundamentally change over time. Things like supply and demand cycles, demographics, innovation, competition, capital at risk, leveraging risks and rewards, greed momentum bubbles, fear and panic overreactions, etc. Since every security is perpetually mispriced and every market cycles to its own tune and time (usually), these cycles do vary in amplitude and duration but while the "frequencies" change over time making the future "different" than the past - music is music despite the tone, harmony, melody, and instrumentation applied in any one song (cycle).


This is why prediction is silly snake oil for us retail folks. MPT is a reasonble and responsive discipline to the realities of both past and future that has no interest in preventing, avoiding, or timing the future....it's a discipline of participation in multiple markets with disjointed cycles, unemotionally selling high to rebalance low with strategic adjustments to changing priorities and circumstances of the investor. And THIS is the value of planning, as planning is a process, begun by project, to factually measure actual future outcomes in relation to planned outcomes for the purpose of responding to future history realized. Planning humanizes the client's experience and allows them to live with purpose and peace of mind without worrying about optimizations and probabilities (interesting as those are). A profound lesson well learned by me is how risk is interjected by strategies designed to reduce other risks - for example; I manage the risk of longevity by reducing my client's quality of retirement life only for them to not experience longevity. There are NO absolutes in our business or in life or in markets - there are only well defined forces in perpetual motion that are not significantly different today than any time in the past.



And all these new ways to overcome the past song/cycle are not new either. Our past is littered with the bones of these "innovations", as one would see if they actually did look in the rear view mirror with understanding and perspective. "This too shall pass....."

[Lucullus]

Bradley,

I get a kick of the kids who have had just enough exposure to "quant" that they've fallen in love.

I recall a fellow in one of my classes who was going on about how wonderful the Whatever Growth Fund was. It had 1, 3, and 5 year track records that beat "the index" and its beta was less than 1.0.

"Really?", I asked. "And what index were you comparing it to?"

The S&P500, he replied.

And what is the R Squared of that fund, with respect to that index?

He didn't know. We looked it up (in the fund literature he had with him, but had obviously not read). It was something like 0.6

Which meant that the Beta of that fund/the S&P meant ZIP.

Another time, one of the agents came into my office (I was a regional marketing consultant at that time) and wanted help with his prospect, Joe. "Joe's a Modified Growth One", he informed me, putting the details of the prospect's portfolio on my desk. "But I think he's really a Modified Income Two, based on our Risk Tolerance questionaire". I'd like your thoughts about how we should reposition his stuff".

[I'm going from memory here; these "quotations" are what I recall; they're not a transcript]

"Hey, Bill", I replied. "I think we might be starting off on the wrong foot here. What does this guy want his money to do for him? What are his projected expenses? How much is he concerned with providing inheritances? What other assets does he have?

Stuff like that.

"Bill" was quite put out with me that afternoon. All he wanted was for me to tell him what buys and sells to make to get the prospect from a Modified Growth One to a Modified Income Two. So what was my problem with that?

My problem with that was, of course, that Joe wasn't a Modified Growth One. Or a Modified Income Two. Those labels denote model portfolios our firm was using. But joe wasn't a model portfolio; he was a human being.

Bill was treating solving Joe's problems as a portfolio management problem. It wasn't. It was a financial planning problem that would incorporate the construction of an appropriate portfolio eventually, but that was much more. Bill had ceased to see Joe as a human with goals, needs, wants, prejudices, etc., because he was focusing on a MODEL that our quant guys felt was probably appropriate for someone who had answered our cutesy Risk Tolerance Questionnaire in roughly the same way Joe did.

Bill was a very successful insurance agent and a decent guy, but he got sucked in to the "wealth management" fantasy that our firm was touting at the time. Everyone became a portfolio. And portfolio construction became a mostly mechanical process of feeding in responses from the "Risk Management Assessment" and the "fact finder".

The worst part of the process was driven by that damned questionnaire. It had questions like "If your investment lost 20% of its value in one year, you would ....(a) buy more of it (b) sell some of it (c) sell all of it (d) shoot myself in the head)."

We give these things to client who come to us for guidance. They have no idea how much "risk" (however they have defined that term) they need to take to get where they want and they need help. So, on first meeting them, we ask them how much risk they are willing to take. To me, that's just plain NUTS! It's like the example I use in my classes and presentations...

Fred, in a strange city on business, has a toothache. He knows nobody and his tooth really hurts, so he looks up "dentists" in the Yellow Pages and goes to see the first one who would see him. He walks into the dentist's office, is ushered into the examinng room, and is asked to sit in The Dentist's Chair.

As he settles uncomfortably in the futuristic looking chair, Fred notices that the dentist has, in his right hand, a huge hypodermic syringe. "Fred', the dentist says. "Tell me how much pain you can endure. And I'll give you enough anesthetic so you will feel that level of pain and no more".

Who would go to such a dentist? Surely, not any of us (he says, knowing that he's addressing an audience of financial planners). But many financial planners - not any of us, of course - handle the client's financial "toothache" in much the same way. The guy comes to us because he wants to know how much risk he bears and how much he must bear, and we respond by asking him how much he'd feel comfortable with.

That's nuts, too. For that matter, the entire body of knowledge that rests upon the notion that "risk" amounts to, and can be adequately represented by, One Year Standard Deviation is nuts! Mean-Variance Optimization, that tells us that, when we go down and to the left on the Efficient Frontier, we lose more risk than we do return (because the efficient frontier curve is rather flat at that point), misses something so important that Albert Einstein called it the most powerful force in the universe - compound interest.

When you go down and to the left on that graph line (where the horizontal axis is One Year SD and the vertical axis is Mean Exected Return for the analysis period), you don't lose only the difference between the beginning and ending values on the Y axis. Unless you assume that investment returns were consumed each year, you lose that difference to the power of N!

I have nothing against Quants. There's much to be said for trying to quantify, so as to understand more precisely. But I have a lot against the notion that financial planning is all about CAPM, MPT, MVO, and MCS. As if we'll know what to say to that anxious client as soon as our computer solves that equation we fed it.

I'm a financial planner. That means that, while I must analyze problems in order to determine best solutions, I'm not primarily an Analyst. Because no solutions are woth a damn until they're implemented. And human beings have a stubborn tendency to resist doing what they ought to do, even when they know what they ought to do. So my job is one of analysis and education and counseling and listening (a LOT of listening)... and, when it's called for... behavior modification.

I like people, a lot more than I like algebra.

- John Olsen

[Bradly T.]

A planner can only agree, and an old planner has plenty of the same stories. I've acquired many clients over the years by my intake process which usually requires 3 meetings prior to any apps or paperwork. At first clients are stumped by the "uniqueness" (sad to say) of the process. It would seem much of my competition is pushing paper in the first meeting to apply a beautifully illustrated model portfolio with impressive lingo and arrogant urgency without asking about debt, cash flow, cash reserves, pending expenses, time horizons, income gaps, insurance needs/holdings, estate priorities, etc. But clients readily recognize the importance of the process once engaged in the process of planning and my competition suffers mightily for it.


Even superior allocation combined with superior fund selection is a sorry second to planning first, even if one then applies superior allocation with subpar funds or subpar allocation with superior funds - the planner's client will have better results (naturally my ego tells me how good I am at everything). This is the very crux of the coming harmonized standard I believe. How little does an RIA have to do to actually deliver fiduciary "advice" and how little must one do to determine and verify "suitable" allocations and products. Can one BE an advisor without planning? Is there such a thing as suitable without planning? Certainly the harmonized standard will NOT require planning first or ever to fulfill any coming obligation(s).



But since the result WILL eliminate any competitive differentiation for both base models, the wonderful result of all this will be the value added competitiveness of the financial planning process provided by practitioners of any and all models. And for us dual hybrids, a unified and uniform process and standard will serve to strengthen our position relative to either base model....a true evolutionary step forward for the industry. An important step to severing the link between product creation and distribution, increasing objectivity and independence for retail distribution and advisory services both.



I can't wait to see the new FINRA required "cost calculator" that ALL RIAs will need to use to compare client costs of management fees with those of loaded, commission paid funds over extended time horizons....you know the one we all love so much that presumes positive growth and killed B shares for many fund families or amounts over $50k. That calculator will create some interesting discussions between RIAs and clients. Dualies Rule! ....or at least Rock



While I am glad that the Noncoalition failed in their attempt to surrender our precious discipline to the SEC/FINRA, it is depressing that this discipline remains so far from a profession and that truly there is no real coalition to forge one. Doubt if I live to see it even as we seem even further away today than 15 years ago....that's the sad part about the Noncoalition's efforts....we've lost even more ground thanks to them.