I found that the FSA is warning that advisors need “to review each portfolio to mitigate the risk of portfolios becoming misaligned“.
That’s true, as far as it goes – but it only goes about three millimetres and then stalls!
The problem is that what they are saying is that
a) you can accurately calculate attitude to risk,
b) you can accurately calculate the risk of a given portfolio.
Regarding a) I’ve said repeatedly (including to the FSA, who simply don’t listen) that the “attitude to risk” questionnaires need a lot more than they’ve got to have any chance of working.
Regarding b) I’ve said that the future is unpredictable and the predictions are just gueses. Therefore advisors take a chance on their reputationevery time they tell a client that “this portfolio carries this degree of risk“
The reason the measures of risk in markets don’t work is that all the statistics used (like Alpha, Beta, Sharp Ratio, etc.) are based on an assumption of normality. If markets were normally distributed, then big movements in stocks would occur with the same frequency as ubelievably tall people occur, every thousand years or so. We’ve had 7 market movements that size in the last 100 years.
Markets are not normally distributed. So the maths doesn’t work.
An underlying assumption of the statistics they use is that the data are independent, as with individual spins of a roulette wheel (and it is artificial situations like that which form the basis of game theory and lots of investment theories, including portfolio theory).
The data are not independent in the real world. Like with the weather, the stock prices one day are not independent of the prices the day before. And the action is continuous, you don’t make a stock purchase, find out whether it wins or loses, make another bet and so on, like in a casino. When does your bet finish and you know whether you’ve won or lost? How does that work with the Hong Kong and New York markets, when does the wheel stop spinning?
So they are using maths that doesn’t apply to the data they’ve got, they don’t understand the nature of the data and consequently they are applying the wrong methods to unsuitable data in the wrong way.
In addition they are measuring “attitude to risk”, in a way that is psychologically flawed and mathematically invalid.
So the FSA is saying “line up factors A and B”, which would be good advice – except that both A and B are mathematically invalid, psychologically nonsensical and largely meaningless.
Given how much the FSA award themselves in terms of bonus for their great work in “keeping investors safe” it would be really nice if they would ask for the help they so desperately need.
Essentially, both advisors and investors need to ignore the FSA guidelines and do some sensible things – like get psychologically valid “attitude to risk” questionnaires standardised and used and use slightly different mathematical procedures with a far greater allowance for error. Of course, the FSA will try to stop that happening, because they are dinosaurs (not only are they cold blooded, but they have a brain the size of a pea located somewhere near their rectum) and resent any progress.
If people did that, and stopped feeding the egos of these idiots, perhaps the FSA would finally learn something and come up to date with cold hard facts.