Most Popular ArticlesNovember 3, 2009
Surprised by the difference? The smaller market relative variability of the passive portfolio (in any one year the index fund is unlikely to vary from the market return by more than 1%) provides a slightly higher confidence when compared to the alpha portfolio (which is likely to vary from the market by far more than 1% in any one year). By including the reality that the 2% certain average outperformance will not occur in the form of exactly 2% each and every single year but instead will vary from year to year, we expose the effect of market relative timing risk in the odds of exceeding our client’s goals.1
Before getting too comfortable with these conclusions, remember that the study period covers 30 years. Do you really think it reasonable to assume an alpha or outperformance average of 2% annually over a near-lifetime of investing?
Loeper answers this question in a practical manner by building a portfolio of ten funds with the same criteria as before, each providing alpha of 2% annually. But most will agree that the odds of picking 10 of 10 stellar funds (2% alpha) over a 30-year period are incredibly small. Take a look at what happens to confidence as the odds become more reasonable – say 4 or 5 out of 10.
Simulations based on $2 million starting balance and 30-year time horizon
Number of |
Confidence |
Annual |
10 for 10 |
84% |
$52,000 |
9 for 10 |
81% |
$47,000 |
8 for 10 |
78% |
$40,000 |
7 for 10 |
75% |
$34,000 |
6 for 10 |
72% |
$31,000 |
5 for 10 |
69% |
$30,000 |
4 for 10 |
65% |
$23,000 |
The far right column shows how much (or how little) income the alpha portfolios would generate if they were forced to the same level of confidence as the passive model – 86%, which you will recall generated $60,000 in annual income. The price of alpha is risk, and the risk is to your lifestyle!
Don’t miss the main point. You cannot spend odds or confidence, only wealth. wealth is what actually affects people’s lives.
There are controllables in the investing process and there are uncontrollables. Market risk is uncontrollable – uncertain as to its timing and degree. Monte Carlo simulations allow us to help plan for market risk. The rest of the variables – costs, taxes, and market-relative performance risk – are controllable. ETFs are very low cost, highly tax-efficient, and can deliver exceptional index tracking. When efficient ETF portfolios are combined with the ongoing oversight necessary to provide high confidence in an ever-changing world, we provide our clients with the best means of harnessing the power of the capital markets to meet their important life goals.
For additional reading of David Loeper’s work:
Stop the Retirement Rip-off, Stop the Investing Rip-off and The Four Pillars of Retirement Plans) released in 2009 by John Wiley & Sons and numerous whitepapers.
Sam Bass is the founder and CEO of Beacon Investment Management, a Raleigh, NC-based fee-only advisory firm, and uses Wealthcare in lieu of traditional financial planning.
1 The study used an 8% market relative variance which means that in 68% of all simulated years, the active fund’s market relative performance will range from underperforming by 5.01% to outperforming by 10.36% while being certain of outperforming on average by 2%.
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