A Misleading Point Of View

In response to the recent article published in your magazine in the June 2005 edition entitled "Stairway To Heaven" by Mitch Anthony:
I am very surprised that a fine publication such as yours published this article. Mr. Anthony‚s entire basis for his argument is very much misleading, and very disconcerting knowing the audience that may have read it. He starts off using an analogy to climbing stairs and posing a hypothetical question to people, asking them in summary if they would prefer only climbing eight stairs on average versus ten stairs, in exchange for potentially falling down only six stairs versus 18 stairs. His premise is that only two stairs‚ difference on the upside is not worth the large "fall" discrepancy. He contends that when he presented this scenario to 50 people, nearly everyone chose the eight-stair average climb over the ten-stair climb. He draws this analogy to investments, and essentially alludes to the fact that there is very little difference between a 70/30 (equity to fixed) allocation versus a 30/70. Not only is this not a good analogy, but it is very much misleading on both the upside and downside analysis.
I grew more and more angry as I read on, hoping that others would not be swayed by this loaded example. First, he selectively uses the average year to demonstrate the upside while he shows the worst year, not the average down year, to demonstrate the down side. Second, he is only using a one-year time frame in posturing his question. So, yes, if for one year and one year only I have the option of choosing an 8% return with a chance at a 6% loss versus a likely 10% return with the chance of an 18% loss, I would opt for the 8% likely return scenario also. What he misses is the fact that, unfortunately for him and his analogy, most investors don‚t have a time horizon of only one year. And those who do shouldn‚t, for the most part, even be considering anything aggressive to begin with.
In that case the difference of 2% is not that great. However, he fails to even hint at the power of compounding. If the question he posed was rephrased to show investors that the mere 2% difference equates to a roughly $44,000 difference after ten years (assuming a starting value of $100,000) or a roughly $206,000 difference after 20 years, then he might get some different feedback. Additionally, he uses the worst year in the 50-year history he analyzed to demonstrate the potential downside. This is a far cry from the average down market difference between the two options he presents, and a market anomaly looking at the complete history. Just as most don‚t expect another 1999 any time soon, most don‚t expect another 2002 either.
What was probably most annoying was the example he used in his effort to explain why percentage points are "the devil‚s pitchfork" in financial services. He calls them a tool than can be "easily used to distort, deceive, manipulate and cloud reality." He recounts a story about a fund in which a man invests money and loses 50% in year one, gains 50% in year two and gains 33% in year three. The end dollar result is $0 net loss or gain. He claims that the fund company‚s prospectus showed a three-year return of 11% (the average of the three years of performance). He goes on to equate this to ongoing accounting scandals and frames percentage performance results as a way to misguide and mislead investors. Well, I‚ve got an update for Mr. Anthony: Mutual funds are not allowed to publish average returns, nor are they statistically meaningful. I defy him to point to one example where a mutual fund shows average returns to demonstrate their performance track record. He will not be able to, because it is not legal to do so. Funds publish annualized performance, which goes through various levels of compliance, and which in his weak example would be 0%, not 11%. His math and his example are shameful and damage his credibility.
There are many other facets of his article that irked me, but in the interest of my own sanity and your time, I‚ll only give you one more. In the section he titles, "Cost of Sleep" he makes the statement, "all the extrapolation and probability analysis in the world is a waste of time" when one single variable changes such as "when a bad year happens." If the bad year comes early, we‚re OK, but if it comes late in the game, it becomes "a personal financial disaster." Well, once again Mr. Anthony has made a broad comment without even considering the contents of his statement. It goes without saying that as an investor gets closer to their goals, or better said, as their time horizon shrinks, their allocation must change to best represent their status. Therefore, Mr. Anthony‚s argument of experiencing a bad year late in the game has no merit (unless you are a lousy advisor). He uses this argument to justify his bashing of probabilities and other quantitative analysis. Well, once again Mr. Anthony fails to take into account that when an investor is "late in the game" their allocation should reflect that, and as mentioned earlier, should be conservative in response to their short time horizon. Therefore his argument holds no water because anyone with one or two years left until retirement, etc., shouldn‚t be aggressive to begin with.
I actually do agree with him on one thing, and that is the need to assess emotions. However, this should be in addition to the quantitative analysis and assessment of the investor‚s financial goals and needs. I do think it is imperative to measure the "sleep factor" of the investor in conjunction with their wealth picture and time horizon. It is certainly not all about numbers. This is very fair and valid. Setting investors‚ allocations and selecting the underlying investments is both art and science. Investors seek professional advice with their investable assets because they are not sure how to best do it themselves. It is up to the financial advisor to give that advice, and allocate their dollars to best fit all of their parameters, not to prey on their emotions through a series of rudimentary and deceptive anecdotes. It is also imperative that the advisor continuously educates along the way. Mr. Anthony‚s attempt to slander asset allocation and drag analytics through the mud in order to make his point was unprofessional, offensive and revealed his naiveté.

Joshua M. Kaplan
Chief Investment Strategist
Smart Financial Advisors LLC
Devon, Pa.

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