November 8, 2011
When you look at this probabilistically, you need to adjust your thinking to understand that all of the outcomes above had the same chance of occurring – each was a 1 in 661 chance. The total range of historical uncertainty for both was around $5 million. A critical eye might observe that at least in these seven trials for these two approaches, the market-cap-weighted approach created more dollars of wealth with higher frequency. But a sample size of seven can be misleading, so I went to the Financeware percentile rankings page and showed all percentiles, which gave me 101 trials to compare (0%-tile through 100th %-tile).
Here is where probabilistic thinking uncovers value for clients. The market-cap weighted portfolio produced more dollars of wealth in 77 of the 101 (76.24%) trials. The average dollar advantage of those trials was $122,000. The equal-weighted allocation exceeded the market-cap approach in only 24 of the 101 (23.76%) trials. The average dollar advantage of those trials was $91,500. The better decision is clear.
Historically, the equal-weighting approach had a 23.76% chance of adding an average of $91,500 of wealth for our sample investor versus the market-cap approach that had a 76.24% chance of adding an average $122,000 of wealth.
Which would you pick?
Other considerations
Certainly history is unlikely to repeat itself, and nor is it an indicator of future results. Only time will tell which of these approaches will add more value for each unique investor. It depends on when they start, what their particular goals are and how those goals change over time. Therefore, it is not a good idea to set an expectation for any investor that one approach will produce superior results. Invariably it will not for some.
Drawbacks for the equal-weighted approach, however, are known with certainty. As mentioned, trading costs, taxes, expense ratios and turnover will be higher. Why would one resign themselves to such certain drawbacks, especially when the historical odds suggest that the approach is actually disadvantageous when compared with a market-cap-weighted approach?
To do the best job for your clients, to help them make the most of their lives, you must go beyond the oversimplified analysis of returns. You have to use probability analysis to uncover facts and expose myths. We look beyond average and median returns to create advice that delivers dollars of wealth that clients can use for goals they value, to enrich their lives and to experience their dreams. It is what we do every day, and it is what gives our careers meaning.
A popular industry speaker and writer, DAVID B. LOEPER is the CEO and founder of Financeware, Inc. in Richmond, VA. He is author of the top selling book Stop the 401(k) Rip-off!, three other books released in 2009 by John Wiley & Sons (Stop the Retirement Rip-off, Stop the Investing Rip-off and The Four Pillars of Retirement Plans) and numerous whitepapers. He has appeared on CNBC, CNN, Fox Business and Bloomberg TV, served on the Investment Advisory Committee of the $30 billion Virginia Retirement System, and was chairman of the Advisory Council for the Investment Management Consultants Association (IMCA). Before founding Financeware in 1999 he was Managing Director of Strategic Planning for Wheat First Union. He earned the CIMA® designation (Certified Investment Management Analyst) from Wharton Business School in 1990 in conjunction with IMCA.
Display article as PDF for printing.
Would you like to send this article to a friend?
Remember, if you have a question or comment, send it to .
