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Chris Gilchrist: It’s official- risk is bunk

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



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There are 20 comments at the moment, we would love to hear your opinion too.

  1. Good article. It always makes me laugh when I see financial planners using cash flow modelling tools that rely on the “efficient frontier” to generate predictions of the next 30 years’ worth of returns.

  2. My thoughts exactly!

  3. Having made the same points myself for a number of years I can but agree 100%. Would be interested though in seeing how you might answer some of the “jam label” examinations – otherwise known as Q level 4. would you tell it like it is or churn out regulatory acceptable nonsense and pass ?

  4. The CAPM assumes an efficient market where knowledge flows freely. This is clearly not the case and the credit crunch lent the lie to this.

    Do not, however, conflate the misuse of the CAPM with a faulty CAPM. Those that used these models either did so knowing that they were the wrong tool for the job (they were trying to weld with a soldering iron) or didn’t realise.

    Either way, none of them should work anywhere near money again without serious re training.

    The fact that the regulators don’t understand is hardly a surprise.

    Looking further into many of the CAPM models used in the UK, they rely on data that uses assumptions based on a model of US interest rates – not the UK. You don’t have to look far to find research published by a Prof at Harvard in 1982 that more or less said you cannot use this model in the UK.

    Yes, there are serious problems with relying on this tool – but it is just that; a tool. If someone can come up with something better than little old me sticking my figurative finger in the figurative air then I’m all ears.

    Until then, I will continue using Stochastic modelling but I will do so with a pinch of scepticism, an ounce of common sense and a pound of caveats.

  5. Personally I would prefer a sensible conversation about risk, illustrated by POSSIBLE future outcomes which show me the POSSIBLE impact of decisions about asset categories rather than an adviser saying “x is more likely than y but I can’t demonstrate what this means for you”.

    Agree models have limitations and won’t be understood by all customers or advisers, but it’s rubbish to say they are bunk. They are just models.

  6. You can nibble at the edges but it only takes Israel dropping a nuke on Iran to strategically change everything for all time!

  7. Careful Chris,

    You’ve got “skin in the game” now with your new enterprise. Statements like “the definition of risk used by UK regulators is bunk” get noticed by our friends at Canary Wharf.

  8. An excellent article. At any time, the investment zeitgeist is an extrapolation of recent history: hence government bonds are the flavour du jour, just as equities were 15 years ago. I amuse myself by monitoring the evolution of the FSA’s (Money Made Clear) text which up until a couple of years ago maintained the standard pub-mantra “equities outperform other asset classes” when the empirical evidence showed that they had underperformed bonds for 15 years. It’s now been deleted, at a time when it might actually have become more relevant again.

    And there is the rub. An IFA who actually uses his brain to assess value in investments is perceived by a regulator as a maverick, and dealt with accordingly, whereas another who follows the junk spewed out of the various “models” ticks boxes but will invariably consign his or her clients to long term underperformance. Is that consumer detriment? I’d say so, the regulator doesn’t. But if it doesn’t, then isn’t “consumer detriment” the same nebulous ill-defined concept that TCF is/was?

    In the long run, any investor hide-bound by a set of rules, who is playing in a market alongside other participants who are not, is doomed. And the more these retail investors are having investment decisions made by a box of complete predictability, the easier it is for the rest of the market to game against them.

    Like Chris, I find it staggering how many times a “new” concept is adopted because it sounds good – stochastic modelling being a case in point. It has its place, but its place is rarely where it is used. I’ve heard regulators recommending stochastic modelling be used when page three modelling might have been a better choice. They often no more know what it means and what it is for than the man on the proverbial omnibus.

  9. Chris, you should be careful lest the regulators think you have ‘serious issues’ and examine your new firm in detail.

  10. A good article in essence, but no suggestions of an alternative Chris, that not only deals with the issues of the current models but also keeps the regulator happy?

  11. Many years ago I managed to get a PhD in theoretical physics. In financial services, the only use for such training is to query assumptions made by so called experts. The real world is more complicated than a simple equation but that never stops academic people trying to find explanations for everything!
    The determinstic approach favoured by the regulator and used by advisers is certainly open to question but we are practicing people not academics and probably don’t have the time or the training to raise fundemental issues. I prefer the Chaos Theory approach (butterfly flaps it wings in South America, we get storms!) when it comes down to analysing risk for a client. How would you explain such concepts to the FSA?
    In the meantime, I will gather historical data, asset allocate and monitor as I have been forced to do but with a little bit of leeway built into the process!
    A model is just that-something to work with. It may or may not be accurate, it should be questioned and refined and there will be conflicting arguments. I think most of the comments here are heartfelt but before you dismiss anything, you need to have something to put in its place!

  12. Chris,

    You really need to read this report (, published by the FSA in January 2011, where they categorically state “Key risks for firms to consider –
    Poor outcomes can occur if firms rely solely on volatility as a proxy for risk”.

    They also mention the need to understand the assumptions used in Stochastic Modelling tools, and the need to establish a client’s Capacity for Loss when investing.

    It is a little concerning this has all seemed to pass many of the industry by.

  13. This is in danger of getting far too complicated!! What we do know is 1)diversification normally lowers risk (and I am considering full multi asset investing here). 2)Investment time horizon is critical to allow recovery, and 3) choosing fund managers who use the windscreen and not the rear view mirror to make investment decisions is key.Adherence to a clients capacity to loss may assist in preserving the nominal value of investments but even here there is inflation risk Cash flow modelling is best used to demonstrate the need to plan early particularly in a low growth environment Simples!!.

  14. Awwww shucks! So someone has actually concluded that the assessment process used to predict the risks associated with an investment are flawed.

    EVERYONE knows that!

    As for whether risk can be taken out of an investment, the only risk free return (allegedly) is to invest in Government Gilts.

    So there you are, let’s all put our clients money into Gilt funds and be done with it.

    Sometimes clever people waffle on about the obvious and don’t engage with the regulator, no need to be afraid, tell it like it is and then if they do not do something about it, we can blame them for any failures. Oh, I forgot, they are not accountable !

  15. A fun article that got people talking – you need to go back to the classroom though Chris and look at points 3 and 4 of Efficient market theory: markets do misprice but nobody can consistantly know when it misprices.

    I have never met any adviser that claimed a fully functioning crystal ball so it is easy to say a stochastic model or cashflow model is not going to achieve perfection because nothing will.

    Having a sensible approach and reviewing it regularly – which I like to think any half decent adviser would should give reasonable results

  16. It is good to see a vigorous rejection of so many of the fairy tales that underpin not only financial advice but also the management of investments. Just because it is possible to manipulate figures does not mean that the resulting answers have any real value. Yet there is an almost religious belief in many of the ratios that swamp the finance industry.
    And the ardour for knowing these numbers is a prime example of why qualifications sometime do as much harm as good. If you have expended a lot of time and energy on learning information there is a strong urge to utilise that information rather than question it’s relevance and usefulness.
    Every index and every ratio produced relates to historical data. They tell of past correlations. They do not tell of causation and are therefore almost irrelevant to the prediction of future events. If there were any solid indication that the future could be deduced from such information we would not have had the financial catastrophes of the last century. I can’t think of any greater proof that current financial knowledge is bunkum.
    And for that reason alone I reject Ken Hayden’s remark that you have to have something to put in its place. What we have is dangerous – even nothing is less dangerous. Why not just toss a coin – Philip Tetlock has amply demonstrated that experts are rarely any better at predicting the future – and most advisers, regrettably, are not experts.
    So why give consumers a false sense of anticipation. I would argue that this is perhaps the worst aspect of current financial advice. There is little doubt that there are many bright people in the finance industry. Alongside that fact is the fiction that they should therefore know what they are talking about. So clients believe this myth and fail to use their own intelligence in assessing propositions. They are then further aided in this abrogation of responsibility by a regulatory system that not only glorifies fairy stories but also provides a solid level of insurance under these stories that IFAs “happily” pay.
    The criticism of the FSA for underpinning these fairy stories is fully merited. The main academic reason for these models is to engage in mind experiments (a little like Schrodinger’s Cat) that stretch the understanding on various topics. The main reason for financial institutions to use these models is as a selling exercise, implying to the consumer a sense of understanding and security that is, in reality, false.
    There have been a number of books over recent years that question not only the mathematical basis of finance but also the psychological and sociological basis of a large segment of the FSA’s assumptions. The great problem is that little is heard of these questions in the media thereby lending credence to both fund manager’s and the FSA’s magnificent grasp on a reality that unfortunately does not exist.
    Long may Chris Gilchrist continue to raise questions on the inappropriate assumptions that ravage the financial industry.

  17. Chris is to be applauded for airing this so succinctly. Our dear Regulator is obsessed with risk and I well recall the set piece they put on at the QE2 centre last year.
    In essence their daft role plays boiled down to one sentence – or Warren Buffets two rules of investing:
    1. Don’t lose money
    2. Refer to rule one.
    Basically what they didn’t bother to cover was the scenario where a client is placed into an entirely unsuitable investment, but makes a packet. Philosophically this is just as wrong as putting someone into an unsuitable product that loses money – but then who is going to complain about the former? Hypocrisy and cant.
    I can well remember a client remark some considerable time ago when discussing risk (yes I have been talking about it to clients for years!). Quote: “I don’t mind taking a risk, Harry. Just so long as I don’t lose money”
    That about sums it up.
    As to these earnest individuals who hold cash flow projections so dear – unlike many I actually have had a life outside Financial Services and run other companies in manufacturing. I well recall back in the early 70’s going to the bank for an overdraft and them asking me for a cash l flow projection. So I told them that IF I get this order and IF the price of raw materials remains steady and labour rates don’t increase and we don’t get any major breakdowns then I can compute £X or prhaps I might get two or three big orders – I can make it what you want – it’s about as good a work of fiction as Charles Dickens. Suffice it to say the requirement was dropped.
    In my opinion there is nothing better than regular valuations (say at least annually) to compare and assess how things are running. That at least is something a lot more tangible than all this supposition. The only difference being that some of these flaky software suppliers won’t make many sales. (Pity that so few can manipulate Excel sufficiently well to be able to dispense with the snake oil salesmen)

  18. I’m just a consumer so the jargon goes over my head but I think Chris is articulating my belief that the regulators have intimidated advisers into uniform pie charts and as little personal thinking and originality as possible…

  19. I think the point coming through from both the article and subsequent comments, is that no one process will ever be appropriate for all circumstances.

    CAPM, efficient frontier, EMH, stochastic modelling all have their place to an extent but what they all share in common is that they are either theories or models, not facts.

    So if we blindly cling to any or all there has to be a risk that if one is investing during one of the many and increasingly frequent periods when the assumptions being used are not borne out in reality, then the outcome will not be as assumed.

    This may be stating the ‘bleeding obvious’ however all too often, common sense is abandoned, over- intellectuallisation occurs and a short sighted or knee jerk approach is adopted.

    Investment process and advice will always be both subjective and objective simultaneously. There will always be winners and losers in both the short and long term but by saving and making provision for short term requirements and investing in a truly diverse fashion over the longer term and regulary reviewing both strategy and tactics, most committed investors should see fair results.

    Not great at algebra so unsure how to articulate this mathmatically!

  20. Well said. It also dovetails nicely with the lunacy of ‘projections’ on ISAs and pensions reported this last week.

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