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Critical maths

Investment is the core of financial planning, so I believe the new exams for advisers should give it greater emphasis. Taking out a mortgage is largely an investment decision, so is buying term insurance. But I fear that, like regulators, whose favourite tool is the rear-view mirror, examining bodies will place too much emphasis on the theory of investment rather than the practice.

As Lord Turner recently remarked, we have been through an almost complete train wreck of financial market theory and regulation. Value at risk, the metric adopted under Basel 2 to assess the banks’ needs for “realistic” capital levels, was gamed by the banks to artificially minimise their need for capital.

Yet the regulators have not dumped VAR – that would lead to awkward questions as to why they adopted it in the first place. Instead, they are simply requiring that banks use VAR and then multiply the resultant need for capital by a factor of two or three. What is the point of learning the theory of a tool that is as broken as this?

Yet I am sure that, like existing exams, the new ones will require IFAs to demonstrate an understanding of risk metrics that banks, traders and regulators are either abandoning or using only when wearing heavy-duty rubber gloves.

I have always been wary of the Greeks (alpha, beta, delta, and the rest). My guide is Warren Buffett, who has said that high-school maths is all any investor needs and that the more complex the maths, the less useful any conclusions drawn from the analysis.

I recently heard David Jane, M&G’s head of multi-asset investing, say that models of portfolio construction and asset allocation do not work. I wonder how many advisers use modelling tools without really understanding them?

For years, I taught advisers the principles of asset allocation without using any of the risk-metric stuff. The principle of diversification is simple and can be applied well without any use of probability theory. It can also be applied using lots of maths but the last two years should have proved this is not a good way to do it. There is too much rear-view mirror involved – we don’t have any statistics about the future. Investing requires judgments about the future, and knowledge of what happened in the past, rather than knowing statistics about what happened, is a better basis on which to make those judgements.

Instead of testing knowledge of the Greeks, I believe adviser exams should focus on the process of formulating and giving investment advice. It is in the application of the principle of diversification that you discover whether an adviser has really got it.

There is only one piece of math that is essential to becom- ing a good investment adviser – understanding compound interest. Try these questions:

If, instead of paying an extra £100 per month off your £100,000 mortgage at an assumed interest rate of 4 per cent for the next 25 years, you invested £100 per month in a fund earning a net annual 7 per cent, how much more would you have at maturity?

a: £15,000
b: £39,000
c: £66,000

If Aethelred the Unready had invested £1 in 1009 at 4 per cent compound, how much would his heirs have today?

a: £10bn
b: £500bn
c: £20,000 trillion

If you didn’t guess right, buy a set of compound interest tables and keep them at your bedside. If they keep you awake, the diagnosis is sad – you need to become an actuary.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report

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