Is 10-Year Back Testing Misleading?

                Recently I had a friend of mine, who had money to roll from a former employer to an IRA, get pitched by a Wells Fargo (WF) advisor and I was outraged enough by what I saw to write this newsletter.

My friend, Jim, is 52-years old, recently took a new job, and he needed to roll just over $200,000 from his 401(k) to an IRA.

The WF rep. ran Jim through a risk questionnaire of some kind and did his magic with the WF software (Envision®) to come up with a recommendation. I was stunned and outraged when I saw it.

Aggressive Growth-for an aggressive growth model, the WF sales output used an 84% equity portfolio and indicated that the drawdown risk is only 15.3% with an average return of 8%.

Conservative Growth-for the conservative growth model, the WF’s sales output used a 68% equity portfolio and indicated that the drawdown risk is only 12.3% (no ROR was listed for this one).

In a footnote it says that there is only a 5% chance that these drawdowns will happen in any given year.

At the end of the WF client piece it literally lists the downside risk of different asset mixes. They are truly stunning.

U.S. Large Cap Equities–Drawdown risk: 15.71% 
U.S. Mid Cap Equities–Drawdown risk:    18.47%
U.S. Small Cap Equities–Drawdown risk: 21.96%

The WF client piece says: “The Historical-Based Planning Assumptions use the average 10-year rolling standard deviation to represent the volatility of the longer-term holding period rather than the yearly standard deviation. The risk and return assumptions are a best estimate to simulate historical market experiences for each asset class.”

To download the 20+ page WF report given to my friend, click on the following link:

http://www.uploadedimages.net/content/PDFs/WF.sales.presentation.pdf

                  Drawdown fantasy world-the WF piece is from a drawdown fantasy world when listing that a portfolio with 84% and 68% equities will only have a 15.3% and 12.3% drawdown respectively (as well as listing the fantasy world drawdown risks for U.S. Large, Mid, and Small Cap stocks).

Historical Drawdowns-Going back to 1961 we’ve had seven stock market crashes. To save space in this newsletter, the following is the average drawdown as well as the drawdown calculated at 84% and 68% of the drawdown (representing the equity mix of both of the WF portfolios listed above).

So, what in the world is going on with the WF numbers? They seem to have no basis in reality. They look to be very misleading to me (making investing in equities seem like a low risk endeavor).

OnPointe Investment Risk Software

We recently had to make some decisions about how we calculate the risk scores of investments in the program. The OnPointe Investment Risk Software was using the industry standard 10-year rolling average, but then we foresaw an issue because it would start losing the drawdown risk associated with the last crash.

The last stock market crash started in October of 2007.

-The 10-year max drawdown of the S&P 500 is 41.79%.
-The max drawdown going back to the 2007 crash of the S&P is 50.78%.
-The max drawdown risk of the S&P going back eight years to July of 2010 is only 16.22%.

What’s my point with the above numbers?

Any software or advisor only using a 10-year rolling average to determine drawdown risk is not taking into account the last stock market crash or the drawdown average over the last 50 years.

As every month passes, the 10-year rolling average drawdown gets smaller and smaller.

What do you show clients?

Is it a good idea to use numbers that do not have a significant crash when talking with clients about the risk in the stock market? I don’t think so. I think it’s incredibly misleading. We will have another stock market crash. It might be this year, it might be next year, or the year after, but we will have one.

Again, the average stock market crash going back to the 1960’s is 39.84%. If that is the case, how could anyone in their right mind give a client, in writing, something that says U.S. Large Cap Equities only have a drawdown risk of 15.71%? It seems insane to think of that happening but yet I have the PDF to prove it.

Summary/Conclusion

This newsletter was supposed to be about why it’s NOT a good idea to use 10-year historical numbers when discussing drawdown risk with clients. It turned out to be about how misleading the WF sales piece appears to be.

Whether you are using software or whether you are calculating historical numbers yourself for clients, I highly recommend that you reach back further than 10 years when discussing drawdown risk in the stock market.

Roccy DeFrancesco, JD
269-216-9978
roccy@strategicmp.net