Morningstar Advisor - February/March 2009 - 80

Phillips Curve You Gotta Look Sharpe By Don Phillips It’s currently quite fashionable to mock quantitative analysis and Wall Street risk models, and no one is sounding this message better or more colorfully than Nassim Nicholas Taleb, author of the bestseller The Black Swan. Ironically, many on Wall Street now use the term “black swan” to describe any event that they couldn’t foresee and, hence, can’t be blamed for having missed. Of course, that’s not even remotely Taleb’s point. His point, it seems to me, is that unpredicted events do occur and that one has a responsibility to be prepared. Clearly, he’s right. Investing occurs in the real world, not in a laboratory setting. We can’t combine certain securities like chemicals in a test tube and get uniformly consistent outcomes. Too many variables cloud the picture and tamper with the results. The world is messy and often unpredictable. But Taleb doesn’t stop with a mere caution about randomness; he urges a virtual overthrow of modern portfolio theory. While there’s great wisdom in Taleb’s insights, one must ask if it really makes sense to toss out a half century of academic research based on his critique. Certainly, it’s nonsensical to believe blindly in the infallibility of academic models—and it can be suicidal to make leveraged bets on the precision of their conclusions—but that’s hardly how most financial advisors that I know use academic research. Advisors have great respect for financial pioneers like Bill Sharpe, but the financial-planning community never really bought into his returns-based style analysis, and no planner that I know would bet the ranch on the infallibility of a Monte Carlo simulation that tells a client they have precisely a 79% chance of meeting their retirement goals. A healthy dose of common sense permeates the planning community. Planners garner from modern portfolio theory the insight that diversification matters. They take from the Sharpe Ratio the notion that risk is an important part of investment evaluation, not that any one calculation can identify the perfect fund. While their institutional brethren may do some foolish things based on a blind belief in financial theory, I see more good than harm flowing from academia into the planning arena, and I suspect that even advisors who buy into Taleb’s worldview won’t abandon all the lessons they’ve taken from academic finance. When it comes to mutual fund risk evaluation, they’ll be making a sound decision. It’s easy to decry the limits of mutual fund risk scores, as these are largely relative risk measures and the current market only highlights the benefits of an absolute approach to risk. But most financial advisors handle their clients’ absolute risk exposure through asset allocation, not through fund selection. All respected advisors advocate that even their smallest clients set aside six months’ to one year’s living costs in a money-market account before they even begin to consider investing in equities. Similarly, most advisors suggest cash reserves to cover several years of spending for their retired clients before they begin their allocation between stocks, bonds, and other assets with the remaining savings. With that framework in mind, it’s worth examining the recent results of mutual funds’ Morningstar Risk scores. We took the trailing three-year risk score published at the start of 2008 and then calculated the subsequent performance of different levels of risk exposure in various broad asset classes through late October. Asset Class U.S. Equity Intl. Balanced Equity Tax Bond Muni Bond High Risk Above Avg Avg Below Avg Low –49.82% –57.15 –35.53 –14.62 –9.93 –45.41 –55.92 –33.86 –43.83 –53.43 –30.03 –42.43 –51.25 –28.46 –38.42 –47.69 –26.18 –9.63 –6.25 –9.56 –4.72 –9.22 –3.65 –7.05 –3.70 Performance Dec. 31, 2007, through Oct. 28, 2008. Groups based on Dec. 31, 2007 trailing three-year Morningstar Risk scores. Clearly, the numbers are horrific on an absolute basis, but on a relative basis, the risk scores performed remarkably well. Not only does nearly every risk gradation add value, but the 6- to 12-percentage-point performance advantage between low- and high-risk funds in each category marks a meaningful difference. While losing less may seem like small consolation, remember that you need to climb 100% to recoup a 50% loss, but only 50% to recover from a 33% loss. Sometimes, relative risk matters quite a bit. So, while it’s imperative that advisors recognize the limits of all quantitative measures, they shouldn’t ignore their potential benefits if incorporated sensibly into portfolio construction. K Don Phillips is Morningstar’s managing director, corporate strategy, research, and communications. 80 Morningstar Advisor February/March 2009

Morningstar Advisor - February/March 2009

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2009

Morningstar Advisor - February/March 2009
Contents
New on MorningstarAdvisor.com
Letter from the Editor
Contributors
Inbox
How Do You Gauge and Measure Risk?
No Skinny-Dippers Here
Heading to Shore
Investment Briefs
Weapons of Mass Destruction?
Déjà Vu All Over Again
A Failure to Gauge Risk
Five Areas to Find Opportunities
Getting a Read on Risk
Heavenly Returns
Greenspring Comes to the Rescue
How to Spot a Trustworthy REIT
Four Picks for the President
Find Succor in These Large Dividends
These Stocks Are Fiscally Fit
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar
You Gotta Look Sharpe
Morningstar Advisor - February/March 2009 - Intro
Morningstar Advisor - February/March 2009 - Morningstar Advisor - February/March 2009
Morningstar Advisor - February/March 2009 - Cover2
Morningstar Advisor - February/March 2009 - 1
Morningstar Advisor - February/March 2009 - 2
Morningstar Advisor - February/March 2009 - Contents
Morningstar Advisor - February/March 2009 - 4
Morningstar Advisor - February/March 2009 - 5
Morningstar Advisor - February/March 2009 - New on MorningstarAdvisor.com
Morningstar Advisor - February/March 2009 - 7
Morningstar Advisor - February/March 2009 - 8
Morningstar Advisor - February/March 2009 - Letter from the Editor
Morningstar Advisor - February/March 2009 - Contributors
Morningstar Advisor - February/March 2009 - Inbox
Morningstar Advisor - February/March 2009 - How Do You Gauge and Measure Risk?
Morningstar Advisor - February/March 2009 - 13
Morningstar Advisor - February/March 2009 - No Skinny-Dippers Here
Morningstar Advisor - February/March 2009 - 15
Morningstar Advisor - February/March 2009 - 16
Morningstar Advisor - February/March 2009 - Heading to Shore
Morningstar Advisor - February/March 2009 - 18
Morningstar Advisor - February/March 2009 - 19
Morningstar Advisor - February/March 2009 - Investment Briefs
Morningstar Advisor - February/March 2009 - 21
Morningstar Advisor - February/March 2009 - Weapons of Mass Destruction?
Morningstar Advisor - February/March 2009 - 23
Morningstar Advisor - February/March 2009 - 24
Morningstar Advisor - February/March 2009 - 25
Morningstar Advisor - February/March 2009 - 26
Morningstar Advisor - February/March 2009 - 27
Morningstar Advisor - February/March 2009 - Déjà Vu All Over Again
Morningstar Advisor - February/March 2009 - 29
Morningstar Advisor - February/March 2009 - 30
Morningstar Advisor - February/March 2009 - 31
Morningstar Advisor - February/March 2009 - 32
Morningstar Advisor - February/March 2009 - 33
Morningstar Advisor - February/March 2009 - A Failure to Gauge Risk
Morningstar Advisor - February/March 2009 - 35
Morningstar Advisor - February/March 2009 - 36
Morningstar Advisor - February/March 2009 - 37
Morningstar Advisor - February/March 2009 - Five Areas to Find Opportunities
Morningstar Advisor - February/March 2009 - 39
Morningstar Advisor - February/March 2009 - Getting a Read on Risk
Morningstar Advisor - February/March 2009 - 41
Morningstar Advisor - February/March 2009 - 42
Morningstar Advisor - February/March 2009 - 43
Morningstar Advisor - February/March 2009 - 44
Morningstar Advisor - February/March 2009 - 45
Morningstar Advisor - February/March 2009 - 46
Morningstar Advisor - February/March 2009 - 47
Morningstar Advisor - February/March 2009 - Heavenly Returns
Morningstar Advisor - February/March 2009 - 49
Morningstar Advisor - February/March 2009 - 50
Morningstar Advisor - February/March 2009 - 51
Morningstar Advisor - February/March 2009 - Greenspring Comes to the Rescue
Morningstar Advisor - February/March 2009 - 53
Morningstar Advisor - February/March 2009 - 54
Morningstar Advisor - February/March 2009 - 55
Morningstar Advisor - February/March 2009 - How to Spot a Trustworthy REIT
Morningstar Advisor - February/March 2009 - 57
Morningstar Advisor - February/March 2009 - Four Picks for the President
Morningstar Advisor - February/March 2009 - 59
Morningstar Advisor - February/March 2009 - Find Succor in These Large Dividends
Morningstar Advisor - February/March 2009 - 61
Morningstar Advisor - February/March 2009 - These Stocks Are Fiscally Fit
Morningstar Advisor - February/March 2009 - 63
Morningstar Advisor - February/March 2009 - Mutual Fund Analyst Picks
Morningstar Advisor - February/March 2009 - 65
Morningstar Advisor - February/March 2009 - 66
Morningstar Advisor - February/March 2009 - 67
Morningstar Advisor - February/March 2009 - 50 Most Popular Equity ETFs
Morningstar Advisor - February/March 2009 - 69
Morningstar Advisor - February/March 2009 - 70
Morningstar Advisor - February/March 2009 - 71
Morningstar Advisor - February/March 2009 - Undervalued Stocks
Morningstar Advisor - February/March 2009 - 73
Morningstar Advisor - February/March 2009 - 74
Morningstar Advisor - February/March 2009 - 75
Morningstar Advisor - February/March 2009 - Most Popular Variable Annuities
Morningstar Advisor - February/March 2009 - 77
Morningstar Advisor - February/March 2009 - 78
Morningstar Advisor - February/March 2009 - New at Morningstar
Morningstar Advisor - February/March 2009 - You Gotta Look Sharpe
Morningstar Advisor - February/March 2009 - Cover3
Morningstar Advisor - February/March 2009 - Cover4
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