HOFFMAN,
WHITE & KAELBER FINANCIAL SERVICES, LLC
Investment
managers & Financial Advisors
This is the August 2004 monthly Wealth Management newsletter from Hoffman, White & Kaelber Financial Services, LLC. If you do not wish to be included in our circulation, please reply indicating your desire to be removed and we will be happy to oblige. Alternatively, any of your friends or colleagues may receive this on a regular monthly basis by sending their name and email address to info@hwkfs.com. Feel free to forward this to any of your friends who may find it useful. Thanks for your interest and I hope you enjoy the letter.
If everything results from of luck, making financial
decisions and managing life’s risks would be a meaningless exercise. Invoking luck obscures truth, because it
separates an event from its cause. When
we say that someone has fallen on bad luck, we relieve that person of any
responsibility for what has happened.
When we say that someone has had some good luck, we deny that person
credit for the effort that might have led to the happy outcome. But how sure can we be? Was it fate or choice that led to the
outcome?
In this letter we will try to
help you develop an understanding that the essence of risk management lies in
maximizing the areas where we have some control over the outcome while
minimizing areas where we have absolutely no control because the relationship
of cause and effect is not readily apparent or hidden from us. Lastly, and as always, we will finish with an update on our
investment activities.
Also, we are sorry that this month’s letter was late in
coming. With vacationing, preparing for
my son – Hank – to go off to college and his need for emergency surgery due to
appendicitis, I’ve fallen a little behind in preparing this month’s newsletter.
Not Enough Information!
While we may assemble big pieces of information and little pieces, it always
seems that we can never get all the pieces together! In addition, we often may never know for sure
how good our information is either. On
top of that, this uncertainty always makes arriving at judgments so difficult
and risky.
When information is lacking, we fall back on inductive
reasoning and try to guess the odds.
Inductive reasoning often leads us to some curious conclusions as we try
to cope with the uncertainties and risks we are left to take. Nobel Laureate Kenneth Arrow has done some of
the most impressive research on this phenomenon. Early on, Arrow became convinced that most
people overestimate the amount of information available to them. The failure of economists to comprehend the
causes of the Great Depression at the time demonstrated to him that their
knowledge of the economy was “very limited”.
In an essay on risk, Arrow asks why most of us gamble now
and then and why we regularly pay premiums to an insurance company? The mathematical probabilities indicate that
we will lose money in both instances. In
the case of gambling, it is statistically impossible to expect more than break
even because the house edge tilts the odds against us. In the case of insurance, the premiums we pay
exceed the statistical odds that our house will burn down or that we will be
burglarized.
Why do we enter into these losing propositions? We gamble because we are willing to accept
the large probability of a small loss in the hope that the small probability of
scoring a large gain will work in our favor.
We buy insurance because we cannot afford to take the risk of losing our
home to fire, or our life before our time.
That is, we prefer a gamble that has certain odds on a small loss and a
small chance of a large gain versus a gamble of uncertain but potentially
ruinous consequences for our family by saving cost and going without insurance.
In practice, however, insurance is available only when the
Law of Large Numbers is observed. This
law requires that the risks to be insured must be both large in number and
independent of one another, like successive deals in a game of poker. It also means that insurance will only be
available when there is a rational way, for the insurance company, to calculate
the odds of loss. Consequently, the
number of risks that can be insured against is far smaller than the number of
risks we take in the course of a lifetime.
In business, we seal a deal by signing a contract or by
shaking hands. These formalities
prescribe our future behavior even if conditions change in such a way that we
wish we had made different arrangements.
At the same time, they protect us from being harmed by the people on the
other side of the deal. Contracts
protect us from unwelcome consequences even when we are coping with
uncertainty. Outside of business, people
guard against uncertain outcomes in other ways.
They call a limousine service to avoid the uncertain ability of getting
a cab or having to rely on public transportation. They have burglar alarms installed in their
homes. Yes, reducing uncertainty can be
a costly business.
How Much Information Is
Enough?
Have you ever noticed that the way you make decisions involving gains and
decisions involving losses may be different?
Where significant sums are involved, would you reject a fair gamble in
favor of a certain gain? Or, if the
choice was different and involved loss, would your decision remain the
same? Also, are our decisions
significantly swayed depending on the size of an expected gain or loss?
Academics believe that we display risk-aversion when we are offered a choice in one setting and then turn into risk-taking when we are offered the same choice in a different setting. We tend to ignore the common components of a problem and concentrate on each part in isolation. We have trouble recognizing how much information is enough and how much is too much. We pay excessive attention to low-probability events accompanied by high drama and overlook events that happen in routine fashion. If true, why is this so?
A 1979 paper on Prospect Theory describes an experiment showing that subjects were first asked to choose between an 80% chance of winning $4,000 and a 20% chance of winning nothing versus a 100% chance of receiving $3,000. Even though the risky choice had a higher mathematical expectation (80% times $4,000 equaling $3,200), 8 out of 10 subjects chose the $3,000. These people were risk-averse. Then the subjects were offered a choice between taking the risk of an 80% chance of losing $4,000 and a 20% chance of breaking even versus a 100% chance of losing $3,000. Now, 9 out of 10 chose the gamble, even though its mathematical expectation of a $3,200 was once again larger than the certain loss of $3,000. When the choice involved losses, the subjects were risk-takers, not risk-averse.
These results, although understandable, are inconsistent with the assumptions of rational behavior. The answer to the question should have been the same regardless of the setting in which it was proposed. From the experiment, the authors conclude, “it is not so much that people hate uncertainty, but rather, they hate losing.”
If you were expecting this newsletter to discuss how probability works or how to predict the future, you may have come away disappointed. My intent was to focus on how people make decisions under conditions of uncertainty and how we live with the decisions we have made. Hopefully, the concepts touched upon will help you develop a more thoughtful approach in evaluating future risks you will face and those risks you will decide to take.
Why Do We Present You This
Discussion On Risk?
At Hoffman, White & Kaelber Financial Services, our focus is to help our clients achieve a more certain future. With our financial planning clients, our goal is to identify the most logical, balanced and efficient path to meet their desired lifestyle now and into the future. And, our asset management clients gain comfort in our conservative strategy of seeking to control risk while carefully and methodically growing their investments.
Hoffman, White & Kaelber Financial Services Investment
Performance Update
It looks like July 2004 signaled the beginning of a new market phase. The Federal Reserve Bank began raising the Fed Funds rate by 0.25%; oil prices hit new highs; and, price volatility is increasing in the US and international equity and fixed income markets. As stated last month, we consider this a major economic event and have already positioned both taxable and non-taxable client portfolios to accommodate this view. Don’t fret! This is the type of market environment that our controlled risk approach becomes appreciated most.
For the month ended
Investment pros borrow a tool from the
statisticians—standard deviation—to measure investment risk. It shows the range of returns that investments are likely to earn
over a given period of time and it has two sides, the out-performance and the
under-performance of an average rate of return.
The Sharpe Ratio is a commonly used measure of portfolio earnings quality. In short, the Sharpe Ratio is a measure of return achieved per risk taken. Sharpe ratios can be better than just looking at performance because it incorporates the issue of risk. Some would say it is a measure of a manager’s ability to perform consistently. The number by itself, however, is hard for many to understand without comparing it to something.
Let’s take a look at the S&P 500 Index for a quick
comparison. The Standard & Poor's
500 Index is usually considered the benchmark for
Are you familiar with Morningstar, Inc.? They are a Chicago-based, global investment research firm, providing information, data, and analysis on the mutual fund industry. They say that a Sharpe Ratio of over 1.0 is "pretty good" and outstanding funds achieve something over 2.0. Using this “yardstick”, we are more than pleased with our accomplishment to date.
For most
investors, the Sharpe makes good intuitive sense because they not only hate to
lose money but they often compare the returns to risk free investing. You owe it to yourself to understand and
consider this measure when making investment decisions.
Is a comfortable retirement or preservation of wealth important to
you?
Want better long-term results from your investments?
Choose Us As Your Investment Manager!
Research us on the web at www.hwkfs.com