One of the consequences of the collapse of neoclassical economic and finance theories is that the definition of risk used by UK regulators is bunk. Markowitz’s theory, mathematically elegant but fundamentally wrong, says risk and return can be traded with knowable and predictable trade-offs between them but this is only true if investment returns fall into a normal or Gaussian distribution, which they do not.
The capital asset pricing model, the ultimate result of Markowitz’s mean-variance theory, has been abandoned by the majority of academics. Yet the “efficient frontier” graphs still trotted out by hundreds of investment management companies depend on CAPM and are meaningless without its assumptions.
More fundamentally, the notion that volatility is a valid proxy for risk – which is the basis of the UK regulator’s assessment of the suitability of advice – is also false.
The dataset of historic returns and probabilistic analysis of them do not provide any form of guide to the future. Laughably, models based on modern portfolio theory currently produce portfolios with heavy weightings in government bonds simply because these have produced excellent returns over the past 20 years and few models use data that goes back further in time.
Yet advisers who put forward investment proposals based on such models are conforming to all the requirements set by regulators and could never be accused of giving poor advice, even if inflation bankrupts their clients.
Conventional theories pretend to a level of knowledge and predictability that is in fact impossible. The extreme example is stochastic models that give a figure for the probability of achieving a given outcome to two decimal places. This is ludicrous and intelligent people should not for a minute contemplate using tools that generate imaginary precision of this kind. You will not just mislead clients but even worse you will mislead yourself into thinking you understand something you do not.
Just to head off defenders of cashflow modelling, I entirely approve of this but you can do it well with a compound interest calculator – a stochastic model adds nothing to the value of the output in terms of guiding clients to better decisions.
Regrettably, many advisers doing cashflow modelling are selling pictures and do not have a clue about how the numbers are generated. If they did, they would know that small changes in a couple of variables can generate huge variations in output.
Entering what I would regard as a sensible range (how about minus two to plus five for the UK inflation rate?) will generate a stochastic fan chart into which you could fit Australia. How useful is that?
Legendary fund manager Peter Lynch used to say: “Never invest in anything you cannot illustrate with a crayon.” I argue that advisers should follow the same principle and only use tools they can explain in simple terms to their clients. Algebra has no place in personal finance, apart from the computations of HMRC and the actuaries.
As for risk, there is no way of reducing it to a number, as conventional theories try to do, because risk is the consequence of uncertainty, which can only be assessed, not enumerated.
We can say “x is more likely than y” without having any sensible way of attaching numbers to the statement. That is the nature of investment. It is time we all stopped pretending otherwise, especially the regulators.
Chris Gilchrist is the joint author of The Process of Financial Planning and editor of The IRS Report