WEALTHCARE CAPITAL MANAGEMENT

EDUCATIONAL EMAIL

W I N N I N G B Y N OT LO S I N G

By David B. Loeper, CIMA®, CIMC®

"Yesterday is not ours to recover, but tomorrow is ours to win or to lose.” - Lyndon Johnson

Over the last couple of weeks, we have been discussing the issue of portfolio implementation in
Wealthcare plans, focusing on controlling that which is controllable, like taxes, commissions,
bid/ask spreads, expense ratios and turnover. (See: Active Passive Management and Confidently
Produce 1.5% in After Tax Alpha.) These elements of true wealth management are not based on
the uncertainty of whether yesterday’s track record will reappear in the future, but instead are
things we can have certainty over controlling tomorrow. Today we will cover another element of
controlling something that is controllable: underperformance risk.

Underperformance Risk – The Most Ignored Risk in Financial Services

You don’t hear much about this risk, yet when it comes to wealth results (as opposed to return
results, which are not the same), it presents a potentially more clear and present danger than many
of the more popular risk measures. It is a real risk that is mathematically provable and avoiding it
has significant real value, yet it is rarely considered. I’ll leave it to you to determine for yourself why
an industry that is supposedly focused on helping people reach their financial goals conveniently
ignores a real risk to their clients’ well being. Instead, I will merely shed some light on what this risk
is, what the wealth impact can be by ignoring it, and how one can control this risk.

Isolating the Effect of Underperformance Risk

If you have followed our work at all, you understand the concept of timing risk; that is the risk of
the uncertainty of when various returns will occur and how that impacts the wealth outcome of each
unique wealth management plan differently. Timing risk often shows counter-intuitive results
where more wealth is accumulated despite lower returns, higher risk or even both. (See Measuring
Temperature with a Ruler or my article on Forbes.)

To measure the impact of timing risk and help advisors guide life choices for clients, many advisors
use Monte Carlo simulation in modeling asset allocation in wealth management plans. Doing this
captures the uncertainty of the timing of asset class returns and how that affects the client’s wealth.

Mathematically, underperformance risk is similar. Keep in mind that when you simulate asset
allocations, you make the assumption that the investments you make will never outperform nor
underperform the model allocation. This is completely analogous to assuming the exact same
return each year in a wealth management plan; both ignore real uncertainties. One assumes your
return will never vary, and the other assumes your return will never vary from the allocation, yet we

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know neither is true. There is a wealth effect to this uncertainty that shouldn’t be ignored. If you
model expenses, it presumes you will under-perform by exactly that amount each year, and if you
model alpha it assumes the alpha will be produced each and every year. Neither of these are
realistic, unless you are implementing a passive portfolio with all of the expenses modeled, because
the passive portfolio has effectively zero chance of out-performing (if matched precisely) nor does it
have a chance of materially under-performing by more than the costs to implement.

Underperformance risk is the extent and uncertainty of when superior and inferior market relative
returns might occur. Like timing risk, this can produce counter-intuitive wealth results depending on
the client’s unique wealth management plan.

A simple example of this is what happens to the wealth of a young investor who is merely
contributing $10,000 a year in an aggressive portfolio, starting back in 1998. If one could out-
perform by 1% each and every year (not just on average) for the first 10 years, all it takes is one
year of underperformance by 3.2% in the 11th year to completely wipe out a decade of consistent,
superior returns. (See Exhibit 1.) This is the effect of underperformance risk.

We do not know whether the investment selected will ever underperform, but we do know that it is
likely to occur at least at some point in the future. We do not know when or by how much, yet it is
clear that each year we are attempting to outperform we are also continuously and repeatedly
subjecting the client to this risk of underperformance. The wealth effect of when, and by how
much, affects each client differently.

Exhibit 1 – One year of underperformance by 3.2% eliminates a decade of out-performing by 1%

Year Allocation Out-Perform Allocation Out-Perform

Return in % Return in % Difference Wealth Result Wealth Result
$10,000 $10,000
1 1998 24.3% 25.3% 1.0% $22,429 $22,529
2 1999 25.3% 26.3% 1.0% $38,096 $38,447
3 2000 -11.4% -10.4% 1.0% $43,748 $44,443
4 2001 -11.1% -10.1% 1.0% $48,872 $49,934
5 2002 -21.1% -20.1% 1.0% $48,538 $49,874
6 2003 31.6% 32.6% 1.0% $73,882 $76,140
7 2004 12.0% 13.0% 1.0% $92,723 $96,013
8 2005 6.2% 7.2% 1.0% $108,437 $112,890
9 2006 15.5% 16.5% 1.0% $135,211 $141,481
10 2007 5.8% 6.8% 1.0% $153,095 $161,145
11 2008 -36.7% -39.9% -3.2% $106,911 $106,850

Now, in Exhibit 1 it should be fairly obvious that the cause of the inferior result was the more
extreme loss in 2008 when the client was at his peak wealth. But, an inferior result could have also
occurred if the portfolio instead out performed by 1% in all years including 2008 and underperformed by
6.4% only in 2007. Both of these scenarios had some chance of happening and are uncertain unless
you know in advance when and by how much, the underperformance will occur. They also both

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had higher returns than the allocation, even though they resulted in less wealth. Do you know
when, or by how much your portfolio might underperform? Do you know the wealth impact to
your client?

Underperformance Risk Isn’t About Controlling Downside Risk

You may have falsely concluded that underperformance risk is about downside protection, but it
isn’t. It is about simply underperforming by some amount at the wrong time for each unique
wealth management plan you are advising.

For example, presume for a moment you have a balanced portfolio management approach that
consistently controls risk and outperforms by 1% in every down year. Also presume that in all but one
of the positive years, this approach either equals or exceeds the balanced allocation you modeled.
However, in one of the positive years (we don’t know which one) the approach will underperform
by 5%. This approach resulted in one of those very marketable track records that produced returns
that are slightly higher than the allocation with significantly less risk. We have ourselves a winner!

When we ignore the risk of underperformance, we end up falsely concluding that the superior
summary return and risk results will also produce superior wealth results. For example, presume
one of your clients in this balanced portfolio started with you in 1998 with $40,000 and planned on
contributing $10,000 a year. The manager outperforms by 1% in each of the four down years of
the last eleven years, equals or exceeds the allocation return in six of the seven positive years, and
underperforms by 5% in just one of the seven positive years. If the underperformance occurs in the
10th year, the result is less wealth than what would have been accumulated by merely owning the
allocation. (See Exhibit 2). If the approach underperforms by 5.5% in the 9th year, once again the
ending wealth for the client is less than merely owning the allocation, despite higher returns, and
less risk (See Exhibit 3). Do you know that you will not underperform your allocation model by
5% in the 10th year? Do you know you won’t underperform by 5.5% in the 9th year? Your
clients who were accumulating wealth in a balanced asset allocation would have been better off in
terms of wealth if they just owned the allocation instead of producing higher returns with less risk.

Of course, you might also use this balanced allocation for clients who are spending wealth instead
of accumulating wealth. Say for example you have another client who is going to spend $8,000 a
year from a $100,000 portfolio for the next 11 years and we have the same scenario where the
manager is going to outperform by 1% in all four of the down years, equal or exceed the allocation
in six of the seven positive years, but underperform in just one positive year by 5%. In this case, the
client would have been better off merely owning the balanced allocation if the underperformance
occurred in year 1 or year 2 again despite it having lower returns and higher risk. (See Exhibits 4 &
5).

Which Clients Will Be Your Victims?

We have seen how clearly some clients will be harmed even if they outperform with less risk,
exceed the market in all down years, and equal or exceed the allocation in six of seven up years.
Some clients would be harmed if the underperformance occurred in the positive markets of year 9
or year 10, and others would be harmed if it occurred in the positive markets of year 1 or year 2.

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Of course, you probably have other clients who would be harmed if the underperformance occurs
in any of the 11 years. But don’t pretend that you are controlling this. It is a real risk that has real
economic costs to at least some of your clients. And don’t pretend that monitoring returns is any
solution to this fundamental problem because you won’t know you underperformed until it has
already occurred.

Controlling Underperformance Risk

Ironically, unlike the uncertainty of whether you will actually produce superior returns in your
attempts to control risk, produce alpha, or even do both as shown in these examples, you can
control the risk of underperformance with near certainty, just like taxes, turnover, spreads,
expense ratios and commissions. But first you have to admit this risk exists and put your client’s
interest ahead of the story the product vendors want you to pitch. There will obviously be some
clients who win with these attempts, but isn’t it misleading to presume some clients are not
harmed? Aren’t the clients who win this game sometimes just the lucky benefactor of when the
superior results occurred, completely out of the control of the supposed management for their
circumstance? Even worse, aren’t some investors unintentionally misled to believe they achieved
superior results (in the form of returns) when for their circumstances the result (in wealth) was
worse?

Look in the Mirror

If you think that you have done a good job managing your clients money because the evidence you
choose to use to judge this is market relative risk adjusted returns, think about these examples and
be honest with yourself. In reality, you don’t know which clients were indeed helped and which
ones were harmed. It is unlikely that they all escaped the wealth effects of underperformance risk,
and a little humility in acknowledging this would be a good first step to becoming a true wealth
manager.

Neither you nor I can control the behavior of markets, and thus we offer advisory services that
accept all of the markets’ uncertainty and advise clients about their goals, priorities, and
dreams…things we can control despite the markets’ uncertainty. Shouldn’t our approach to
implementing portfolio allocations from a client’s Wealthcare plan also focus on those things we
can control?

Add up the wealth benefits to those things we can have confidence in controlling. Is there value to
tax location management? Yes. Is there value to minimizing needless trades and short term gains?
Yes. Is there benefit to minimizing expense ratios and often hidden bid/ask spreads? Yes. Is there
benefit to minimizing turnover? Yes. (Last week we showed how this benefit alone could equate to
a 1% after tax alpha.) Is there a benefit to eliminating underperformance risk? Yes. These are all
things we can control with near certainty and when combined they add up to a very large wealth
benefit for our clients. Isn’t wealth management about making good decisions about the things you
can control in the context of the uncertainties you cannot control (like which year you will
outperform, underperform or how the markets will behave)?

Managing that which is manageable…This is the future of financial advising

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Exhibit 2 – One year of underperformance by 5% in year 10 eliminates the benefit of higher return and less risk for
investor contributing $10,000 a year to a $40,000 account.

Allocation Out-Perform Allocation Out-Perform

Return in % Return in % Difference Wealth Result Wealth Result
Year $40,000 $40,000
1 1998 18.8% 18.8% 0.0% $57,503 $57,503
2 1999 13.7% 13.7% 0.0% $75,376 $75,376
3 2000 -0.9% 0.1% 1.0% $84,694 $85,447
4 2001 -4.1% -3.1% 1.0% $91,231 $92,808
5 2002 -7.2% -6.2% 1.0% $94,634 $97,026
6 2003 20.0% 20.0% 0.0% $123,574 $126,445
7 2004 8.9% 9.9% 1.0% $144,592 $148,982
8 2005 4.9% 5.9% 1.0% $161,691 $167,787
9 2006 10.3% 10.3% 0.0% $188,410 $195,136
10 2007 7.3% 2.3% -5.0% $212,204 $209,665
11 2008 -15.7% -14.7% 1.0% $188,886 $188,843
Risk (SD) 11.1% 10.7%
Compound Return 4.54% 4.67%

Exhibit 3 – One year of underperformance by 5.5% in year 9 eliminates the benefit of higher return and less risk for
investor contributing $10,000 a year to a $40,000 account.

Allocation Out-Perform Allocation Out-Perform

Return in % Return in % Difference Wealth Result Wealth Result
Year $40,000 $40,000
1 1998 18.8% 18.8% 0.0% $57,503 $57,503
2 1999 13.7% 13.7% 0.0% $75,376 $75,376
3 2000 -0.9% 0.1% 1.0% $84,694 $85,447
4 2001 -4.1% -3.1% 1.0% $91,231 $92,808
5 2002 -7.2% -6.2% 1.0% $94,634 $97,026
6 2003 20.0% 20.0% 0.0% $123,574 $126,445
7 2004 8.9% 9.9% 1.0% $144,592 $148,982
8 2005 4.9% 5.9% 1.0% $161,691 $167,787
9 2006 10.3% 4.8% -5.5% $188,410 $185,908
10 2007 7.3% 7.3% 0.0% $212,204 $209,518
11 2008 -15.7% -14.7% 1.0% $188,886 $188,718
Risk (SD) 11.1% 10.6%
Compound Return 4.54% 4.64%

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Exhibits 4 & 5 – One year of underperformance by 5% in year 1 or year 2 eliminates the benefit of higher return
and less risk for investor withdrawing $8,000 from a $100,000 account.

Allocation Out-Perform Allocation Out-Perform

Return in % Return in % Difference Wealth Result Wealth Result
Year $100,000 $100,000
1 1998 18.8% 13.8% -5.0% $110,756 $105,756
2 1999 13.7% 13.7% 0.0% $117,921 $112,237
3 2000 -0.9% 0.1% 1.0% $108,854 $104,343
4 2001 -4.1% -3.1% 1.0% $96,403 $93,120
5 2002 -7.2% -6.2% 1.0% $81,433 $79,318
6 2003 20.0% 20.0% 0.0% $89,731 $87,193
7 2004 8.9% 9.9% 1.0% $89,731 $87,839
8 2005 4.9% 5.9% 1.0% $86,136 $85,030
9 2006 10.3% 10.3% 0.0% $87,043 $85,822
10 2007 7.3% 7.3% 0.0% $85,415 $84,105
11 2008 -15.7% -14.7% 1.0% $64,005 $63,741
Risk (SD) 11.1% 10.2%
Compound Return 4.54% 4.72%

Allocation Out-Perform Allocation Out-Perform

Return in % Return in % Difference Wealth Result Wealth Result
Year $100,000 $100,000
1 1998 18.8% 18.8% 0.0% $110,756 $110,756
2 1999 13.7% 8.7% -5.0% $117,921 $112,384
3 2000 -0.9% 0.1% 1.0% $108,854 $104,490
4 2001 -4.1% -3.1% 1.0% $96,403 $93,262
5 2002 -7.2% -6.2% 1.0% $81,433 $79,452
6 2003 20.0% 20.0% 0.0% $89,731 $87,353
7 2004 8.9% 9.9% 1.0% $89,731 $88,015
8 2005 4.9% 5.9% 1.0% $86,136 $85,216
9 2006 10.3% 10.3% 0.0% $87,043 $86,028
10 2007 7.3% 7.3% 0.0% $85,415 $84,326
11 2008 -15.7% -14.7% 1.0% $64,005 $63,930
Risk (SD) 11.1% 10.4%
Compound Return 4.54% 4.70%

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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 white-
papers. He has appeared on CNBC 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.

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WEALTHCARE RESOURCES

New Books Available on Amazon and Barnes & Noble, and Borders!
Stop the Retirement Rip-Off
Stop the Investing Rip-Off
The Four Pillars of Retirement Plans

No Time to Read Loeper’s Books? Sign up for our free webinars!

David Loeper will be hosting three 30 minute webinars beginning in September; each one covering the key
information from each of his books released this year. To sign up, click on the links below, or e-mail
support@wealthcarecapital.com.

Stop the Investing Rip-Off Recorded Webinar – Recorded version now available online!
The Four Pillars of Retirement Plans Webinar – Sept. 29 at 4:15 ET
Stop the Retirement Rip-Off Webinar – Oct. 6 at 4:15 ET

The Wealthcare Movement In the News

Read about how our advisory board members are changing financial services to make the most of their clients’ lives,
and their own.

Mowry Young – Building a Practice in America’s Fastest Dying City

David Loeper – The Compound Return Shell Game

Russ Thornton – The Levers to Financial Freedom

Updated Value Proposition Power Point Available

We’ve updated the look and feel of our popular Wealthcare value proposition presentation for clients. Click here to
open it.

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“W i n n i n g b y N o t L o s i n g ” September 23, 2009 © Wealthcare Capital Management All Rights Reserved

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