By Mike McDaniel
Chief Investment Officer at Riskalyze
Today I’m incredibly excited to share about two meaningful enhancements to our calculation methodology that will take effect on January 7th, 2019. We’re updating our “Long Term Consensus” capital market assumptions and improving the way Riskalyze approaches young investments, and I’d love the opportunity to fill you in.
Putting the “Long” in Long Term Consensus
Since we rolled out “Advanced Risk Modeling” back in 2016 we’ve seen thousands of advisors take advantage of the feature, incorporating a six-month outlook for the US Equity and US Bond markets into the calculation of the Risk Number® and 95% Probability Range of their portfolios. With Advanced Risk Modeling, we’ve equipped advisors with the ability to completely customize these market risk assumptions.
In the last two years, though, we’ve found that over 60% of advisors have opted to use our default “Long Term Consensus” capital market assumptions instead of using custom inputs. Now, it’s time to enhance our default marketing assumptions.
The original Long Term Consensus inputs were established based on a 30-year historical dataset, but we’re often asked to take that a step further.
So now, based on 827 months of data from 1950 to present, our US equity assumption will decrease from a modeled return of 5.20% to 3.75%. The US Bond market input will remain unchanged at 0 bps, based on US bond market return data going back to 1962.
Advisors using our Long Term Consensus capital market assumptions may see a meaningful shift in Risk Numbers and Riskalyze GPAs™ (for example, the lower return outlook of an equity-rich portfolio will likely produce a higher Risk Number).
Moving forward, our team will recalculate these values on a bi-annual basis and make changes if a material difference to either US Equity or US Bond market emerges. We define "material" as a change in the US Equity Market value of at least 25 bps or a change in the 10-year Treasury value of at least 5 bps.
Upgrading Young Investment Extrapolation
We’re often asked about our analysis of investments with a limited history and we believe that having a “lucky” inception date (not existing during a bear market) shouldn’t benefit the analysis of a new investment over others.
We refer to those with an inception date more recent than January 1, 2008 as "young investments."
Our objective is to empower you to set realistic expectations with robust analysis. With that in mind, we use our existing extrapolation methodology to adjust volatility, and an updated annual return ratio to adjust the stated probable annual return on young investments.
For advisors using Average Return mode, we’ll now adjust the potential annual return of young investments commensurate with the return of the US stock market. We’ll use a ratio that compares the return of each young investment to the return of the US stock market (as measured by the S&P 500 index) and we'll adjust the displayed potential annual return accordingly.
Consider two investments that both track the S&P 500 index but have wildly different inception dates. One has a lucky inception date in September 2010 (no bear market data) and has an annual average return of 14.14%. The S&P 500, with a full data set (as measured from June 1, 2004), has an annual average return of 8.62%. Allowing the inception date to promote the less-seasoned investment as superior is counterintuitive. We’re addressing this with a simple ratio adjustment.
Since the inception date of the young investment, the S&P 500 measures an annual average return of 14.44%. By dividing these values (14.14% ÷ 14.44%), we end up with a ratio of 0.98. Then we’ll adjust the returns proportionally to generate an adjusted average return number for our young investment. In this case, its annual average return would be 8.44% (8.62% * 0.98).
This updated methodology will even the playing field between young investments and investments with the full data set. This change will only affect the analysis for investments in Average Return mode, so advisors using this mode may notice Risk Number and/or Riskalyze GPA changes as a result of this update.
We remain committed to measuring investment risk objectively, and as always, we’re thankful that you’re empowering the world to invest fearlessly. We love being a small part of your success. Any questions? The industry’s best support team would love to help at [email protected].