Evidence Based Management Revisited
Dr. Frank A. Sortino, Founder & Director of PRI
Since 1981 The Pension Research Institute (PRI) has been providing evidence that Post Modern Portfolio Theory (PMPT) is a better way to construct and manage portfolios. In chapter 6 of my first book my colleague, Dr. Joseph Messina pointed out how value at risk (VAR) was inappropriate for risk averse-investors. This was particularly true for those who view risk as the failure to earn a specific return needed to achieve their financial goal, like replacing a percentage of their income at retirement.
Now, Professor Savage at Stanford University in his book, “The Flaw of Averages”provides further evidence on the shortcomings of standard deviation and makes some interesting observations on decision making under conditions of uncertainty. In Chapter 24 he cites two approaches to help investors manage risk. The first approach was used by the $50 billion Bessemer Trust which presented four portfolios with 0%, 50%, 70% and 100% equity exposure. The remainder was invested in bonds. Risk was measured as the worst outcome experienced over different periods between 1946 and 2005. The worst 5 year period for the 100% fixed income portfolio was -2.1% while the worst 5 year period for the 100% equity portfolio was only -.8%. Lest you conclude bonds are riskier than stocks, the worst 1 year interval for the 100% equity portfolio was -25.6%.
This provides evidence that a five year glide path was sufficient for 401(k) participants even if they were 100% in equity during crises like the Korean War, the Cold War, the Cuban Missile Crisis and Viet Nam. Politicians and consultants would be wise to buy Stanford Professor Jeffrey Pfeffer’s book on evidence based management (visit www.evidence-basedmanagement.com) so they could stop relying on their emotions and start looking at the evidence before making misguided decisions that make it more difficult for working class citizens to retire with dignity. Forcing 401(k) participants to exit from equities 10 years before retirement is like pilots beginning their approach to JFK when they are over Chicago.
The second approach mentioned by Professor Savage is the Financial Engines 401(k) service. In this case, the participant goes to the Financial Engines website to run a computer program that generates a probability distribution of possible outcomes based on economic scenario forecasts and choices of assets from a database of thousands of managers. The output is pictures of weather forecasts ranging from stormy to sunny skies that depict the chances of replacing various percentages of income at retirement.
So, what’s wrong with that? The same thing that is wrong with asking someone who has never flown to take over the airplane and land it at JFK. THEY ARE NOT QUALIFIED! Investing is not easy and any attempt to make it appear so, is at minimum misleading, and possibly inviting portfolio suicide. Before asking a 401(k) participant to construct a suitable portfolio and manage it through all kinds of financial storms they should require an answer to the following question: How many people do you know that would pay you to manage their portfolio? If the answer is zero, the computer should blast out, “THEN WHY WOULD YOU HIRE SOMEONE THAT NO ONE ELSE WOULD HIRE”!
If the government really wants to protect investors from incompetent management they should begin by discouraging do-it-yourself programs and encourage investors to seek the best professional Financial Advisors they can afford.