Kylie Minogue Asset Models & Who cares anyway

Martyn DoreyConsultant

2 December 2003

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2

Objectives• Split presentation into three parts• Epistemology

– Influence of internal culture on modelling– Reflections on debate earlier

• Technical– Pay attention here comes the science bit– Behavioural aspects of optimisation– How do you put a price on the downside

• Do we care?– What are the big issues we need to be

thinking about over the year– Plan for next year

3

Step back in time

• Whats the Kylie link?• This is an accessible conference• Fancied doing something different

from neighbours & went into competitive pop business

• Early success was short lived• Culture changed• Found herself out of a job• What was wrong?

4

Wouldn’t change a thing -

• Kylie ultimate consultant:• Reinvent approach every decade

using latest technology• Responded to changing cultural

environment• Measurable feedback on approach• Did not specialise but got better at

everything• Anything goes• Above all took risk• Got involved in the creative process

5

Kylie Vs. actuarial risk modelling • Creative thinking?

– Is culture is stagnant• Press - do we take it too seriously?

– Competitive approach in press and talks

• Competitors in the top 40 – Breadth and depth of product

philosophies/styles– Similar models used– 4 advisors 65% of FTSE 100

• Change of direction interpreted– weakness not creative strength

• Bitchy? – Use competitors good ideas– Finish other peoples ideas

• Integrated vs. segregated– Get involved in creative process– Seek contemporary creativity

• Trying to be ‘hard’– You can still be normal

6

Getting ideas out.

• Express risk as – Potential funding level– Potential contribution rate rises

• Analysis examines different outcomes based on a simple bell curve

• Most people concerned with poor experience

• Also consider better than expected100% funded

Average in the middle

90% of time X funded or better

Poor experience

Gray area = 90%

Better than average experience

1/3 of time Y funded or better

Gray area =33%

7

Mini case study (1)

• Client likes bonds• With very little information from actuary

basis for discussion

8

Shocked

N:\2-Product Development\RiskBudgeting\[RiskBudgeting.xls]OutputSheet 0.1

Asset mix & est. one year downside "90% of the time funding levels will be above"

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

140.0%

160.0%

180.0%

200.0%

100: 0 90: 10 80: 20 70: 30 60: 40 50: 50 40: 60 30: 70 20: 80 10: 90 0: 100

Asset mix Equities: Bonds

OngoingDiscontinuanceFRS17MFR

Asset mix & est. one year downside "10% chance that contribution rates will rise by"

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

100: 0 90: 10 80: 20 70: 30 60: 40 50: 50 40: 60 30: 70 20: 80 10: 90 0: 100

Asset mix Equities: Bonds

OngoingDiscontinuanceFRS17MFR

9

I should be so lucky

N:\2-Product Development\RiskBudgeting\[RiskBudgeting.xls]OutputSheet 0.66

Asset mix & est. one year downside "1/3 of the time funding levels will be above"

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

100: 0 90: 10 80: 20 70: 30 60: 40 50: 50 40: 60 30: 70 20: 80 10: 90 0: 100

Asset mix Equities: Bonds

OngoingDiscontinuanceFRS17MFR

Asset mix & est. one year downside "1/3 chance that contribution rates will rise by"

-1.8%

-1.6%

-1.4%

-1.2%

-1.0%

-0.8%

-0.6%

-0.4%

-0.2%

0.0%100: 0 90: 10 80: 20 70: 30 60: 40 50: 50 40: 60 30: 70 20: 80 10: 90 0: 100

Asset mix Equities: Bonds

OngoingDiscontinuanceFRS17MFR

10

Je Ne Sais Pourquoi?

Asset mix & impact on benchmark risk

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

100: 0 90: 10 80: 20 70: 30 60: 40 50: 50 40: 60 30: 70 20: 80 10: 90 0: 100

Asset mix Equities: Bonds

OngoingDiscontinuanceFRS17MFR

• 100% Equities– MFR low risk– FRS17 high risk

• 100% Bonds – MFR high risk– FRS17 low risk

• 50:50 lowest risk against all benchmarks

11

Obsession: Behavioural finance• Myopic risk aversion• Hope for out-performance • Need risk to outperform in long term• Too much risk under-perform in short

term

Probability of achieving objective

0

0.1

0.2

0.3

0.4

0.5

0.6

0.00

0.01

0.02

0.02

0.03

0.04

0.05

0.06

0.06

0.07

0.08

Risk against benchmark

Prob

whe

re IR

= 0

.36

12

Obsession: Behavioural finance• Myopic risk aversion• Hope for out-performance • Need risk to outperform in long term• Too much risk under-perform in short

term

0

5

10

15

05

1015

20250

0.2

0.4

0.6

0.8

SkillIncreasing skill

Probability of achieving objectives

Active riskIncreasing risk

13

Obsession: Behavioural finance• Myopic risk aversion• Hope for out-performance • Need risk to outperform in long term• Too much risk under-perform in short

term

0

5

10

15

05

1015

20250

0.2

0.4

0.6

0.8

SkillIncreasing skill

Probability of achieving objectives

Optimum risk

14

Obsession: Behavioural finance

Probability of achieving objectives

manager information ratio

activ

e ris

k

15

Word is out: Cost to risk• It’s not ‘hard’• Behavioural method?• If things go wrong how much do you have

to pay?• Looks only at downside• Works with any distribution you like –

here we will use stochastic• Could be thought of as an option• You will exercise option if your assets

don’t deliver the goods

16

Cost to risk: What do I have to do?• Calculate the option:• PV(Min(x-obj),0)• Determine a benchmark• Determine an objective• Calculate distribution around this• Work out the mass function• Then calculate the expected value of

downside

17

Global Equity Return 8.7% 32.9% 47.1% 48.5% 14.8% 51.2% 68.5% 68.1%Global Fixed Income Return 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Global Index Linked Return 85.0% 57.9% 32.9% 27.9% 75.7% 33.6% 1.5% 0.0%Global Property Return 6.3% 9.2% 20.0% 23.6% 9.5% 15.2% 30.0% 31.9%Global ARF Return 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Global Corp Return 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Exp Return relative year : 5 -12.7% -4.9% 0.1% 0.8% -22.2% -10.7% -4.8% -4.8%Exp Return relative year : 10 -25.4% -3.6% 10.7% 12.6% -47.9% -15.4% 1.5% 1.5%Exp Return relative year : 15 -37.2% 10.1% 42.1% 46.3% -76.4% -4.4% 34.3% 34.3%Exp Return relative year : 20 -46.7% 43.1% 106.8% 115.4% -107.6% 33.5% 114.0% 114.0%Exp Return relative year : 25 -52.7% 104.1% 220.5% 236.3% -141.2% 112.6% 265.3% 265.1%Exp Return relative year : 30 -51.6% 212.4% 417.9% 446.4% -174.0% 266.9% 548.3% 547.9%

Prob failing objective year : 5 99.5% 62.9% 51.1% 50.1% 99.5% 67.5% 58.0% 57.7%Prob failing objective year : 10 99.8% 57.7% 42.7% 41.6% 99.8% 67.0% 53.2% 53.3%Prob failing objective year : 15 99.1% 47.3% 32.7% 31.8% 99.5% 58.4% 46.1% 46.1%Prob failing objective year : 20 96.2% 37.1% 24.4% 23.4% 98.3% 50.5% 38.6% 38.6%Prob failing objective year : 25 91.4% 27.5% 16.9% 16.3% 95.9% 43.5% 31.1% 31.2%Prob failing objective year : 30 84.1% 19.2% 10.7% 10.2% 93.0% 36.2% 25.2% 25.1%

Exped Loss year : 5 -12.7% -9.4% -10.0% -10.2% -22.2% -17.0% -17.8% -17.9%Exped Loss year : 10 -25.5% -13.6% -13.0% -13.2% -47.9% -28.6% -27.5% -27.6%Exped Loss year : 15 -37.2% -15.0% -13.1% -13.2% -76.5% -37.1% -33.7% -33.8%Exped Loss year : 20 -47.4% -14.7% -12.0% -11.9% -108.1% -43.9% -38.2% -38.1%Exped Loss year : 25 -55.7% -13.3% -10.3% -10.2% -143.8% -49.1% -41.0% -40.9%Exped Loss year : 30 -61.1% -11.0% -8.0% -7.9% -182.3% -51.7% -40.9% -40.8%

Beat ILG by 3%, reduce downside Beat ILG by 5%, reduce downsideAsset Allocation Asset Allocation

Output (1)

18

Output (2)Beat ILG by 3%, reduce downside

0%10%20%30%40%50%60%70%80%90%

100%

Years1:1

Years2:2

Years3:3

Years4:4

Years5:5

Years6:6

Years7:7

Years8:8

Years9:9

Years10:20

Years20:30

Global Corp Return

Global ARF Return

Global Property Return

Global Index Linked Return

Global Fixed Income Return

Global Equity Return

19

Who cares:• What is the biggest issue for the younger

members• Generate

• something you would like to hear someone talk about

• Something that you would like to talk about• Opportunity to practice• Try out some ideas