1. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E ARE YOU MODELING WHAT YOU INTENDED? David B. Loeper, CIMA, CIMC Chairman and CEO – Wealthcare Capital Management dloeper@wealthcarecapital.com 804-644-4711

2. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 2 What are Capital Market Assumptions (CMAs) Anyway? For Purposes of Monte Carlo Simulation OR Optimization: The Average (mean, arithmatic mean) of Millions of Returns Center of the distribution The Standard Deviation of Returns (uncertainty) Extent and frequency returns vary from the mean The Correlation of Returns to Other Assets Degree of association between two random variables

3. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 3 What are Capital Market Assumptions (CMAs) Anyway? For Purposes of Monte Carlo Simulation OR Optimization: The Average (mean, arithmatic mean) of Millions of Returns Center of the distribution The Standard Deviation of Returns (uncertainty) Extent and frequency returns vary from the mean The Correlation of Returns to Other Assets Degree of association between two random variables Together, these define the shape of a RANDOM distribution and ARE NOT A FIXED RELATIONSHIP in A Monte Carlo TRIAL

4. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 4 Statisticians draw these distributions as a bell curve (Log normal distributions have a slightly longer tail at one end) Extent Frequency Mean Standard Deviation

5. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 5 Statisticians draw these distributions as a bell curve The bell curve can define AN ASSET CLASS High Risk Asset Class Low Risk Asset Class Low Mean & Risk High Mean & Risk

6. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 6 Statisticians draw these distributions as a bell curve The bell curve can define AN ASSET CLASS Or A PORTFOLIO when two or more classes are combined (based on the correlation between the two) 50% Mean More Efficient Portfolio High Risk Asset Class Low Risk Asset Class Low Mean High Mean 50% Degree of Covariance

7. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 7 Imagine the “bell” flipped over and filled with a million numbers Extent Frequency Mean 1011 14 24 7 1 18 8 12 9 -3 -11 -22 28 35 45 9131119 2 510 121626 -9 13 2747 52-38 -45 61 -5-21 -28 38 18 11 261412844148

8. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 8 Imagine the “bell” flipped over and filled with a million numbers The CMAs define the population of numbers in the “bell” Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148

9. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 9 The CMAs define the population of numbers in the “bell” If we stirred them, blind folded you, & asked you to pick A SMALL percentage of the numbers What’s your chance of picking?…. Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Just these?

10. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 10 The CMAs define the population of numbers in the “bell” If we stirred them, blind folded you, & asked you to pick A SMALL percentage of the numbers What’s your chance of picking?…. Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Just these? Or, Just these?

11. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 11 The CMAs define the population of numbers in the “bell” What’s your chance of picking?…. Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Just these? Or, Just these? Monte Carlo Simulates this random “picking” BASED ON THE BELL (bowl) DEFINED BY THE CMAs

12. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 12 The CMAs define the population of numbers in the “bell” Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Just these? 5% Chance Or, Just these? 5% Chance In Seeking RATIONAL confidence, WITHOUT undue sacrifice, do we advise clients to live their life based on REMOTE EXTREMES THAT NEVER HAPPENED?

13. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 13 The CMAs define the population of numbers in the “bell” Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Just these? 5% Chance Or, Just these? 5% Chance In Seeking RATIONAL confidence, WITHOUT undue sacrifice do we advise clients to live their life based on REMOTE EXTREMES? Or REASONABLE CONFIDENCE? <18% Chance or 82% Confidence of EXCEEDING

14. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 14 The CMAs define the population of numbers in the “bell” Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Just these? Or, Just these? But, IF WE MAKE POOR ASSUMPTIONS in the SHAPE of the Bell, we could be CREATING: UNDUE SACRIFICE or TOO MUCH UNCERTAINTY 10% <18% Chance

15. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 15 The CMAs define the population of numbers in the “bell” IN THIS CASE, 82% Confidence is likely FAR worse than any market we have ever seen! SACRIFICE!! Extent Frequency Mean 10 -3 11 14 24 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Missing only a few returns (some HIGH ones) changes ALL of the odds 7% Only 50% Confidence of EXCEEDING What Had Been 82% Remote outcome no longer within population 52

16. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 16 The CMAs define the population of numbers in the “bell” 82% Confidence of DOING ABOVE AVERAGE?! TOO MUCH UNCERTAINTY Extent Frequency Mean 10 -3 11 14 24 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 Missing only a few returns (some LOW ones) changes ALL of the odds 13% 82% Confidence of EXCEEDING What Had Been only 50% Remote outcome no longer within population Higher Confidence of previously remote extreme

17. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 17 CRITICAL POINTS TO UNDERSTAND With more COMPLETE populations, we can understand: Where reasonable confidence falls Remote extremes (those possible but never seen events) It is intuitive that if you select a small sample, it is very unlikely they will ALL be one extreme or the other Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148

18. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 18 CRITICAL POINTS TO UNDERSTAND With more COMPLETE populations, we can understand: Where reasonable confidence falls Remote extremes (those possible but never seen events) It is intuitive that if you select a small sample, it is very unlikely they will all be one extreme or the other Extent Frequency Mean 10 -3 11 14 24 52 -11 -22 -38 -45 7 1 18 28 35 45 61 8 9 12 131119 9 2 510 121626 -9 -5-21 -28 13 274 38 18 11 7 261412844148 What is harder to understand is how unlikely it is that a LARGER sample would be representative of the entire population…Thus skewed… or fooled?

19. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 19 We Can Easily Be Fooled (by randomness) How Many Of You Think a Compound Return for Large Cap should be 10% or less?

20. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 20 We Can Easily Be Fooled (by randomness) How Many Of You Think a Compound Return for Large Cap should be 10% or less? 30 Years 1974- 2003: 12.08% 30 Years 1973-2002: 10.55% 30 Years 1927-1956: Think we should be careful in using a 30 year data set? ONE year changed compound return by 1.5%!!!!

21. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 21 We Can Easily Be Fooled (by randomness) How Many Of You Think a Compound Return for Large Cap should be 10% or less? 30 Years 1974- 2003: 12.08% 30 Years 1973-2002: 10.55% 30 Years 1927-1956: 10.06% (expecting depression as NORM?) 20% of Historical 30 Year Periods <10% 50% of Historical 30 Year Periods >10.82% 51% of Historical 30 Year Periods >10.85% (monthly data) Our CMAs: 12.32% (mean) & 18.38% SD= 10.85% Compound Our CMAs at 77 th %-tile: 8.30% at 87 th %-tile: 7.17% Worst 30 Years of History (annual data): 8.47% (1929-1958) Worst 30 Years of History (monthly data): 7.17%

22. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 22 We Can Easily Be Fooled (by randomness) How Many Of You Think a Compound Return for Large Cap should be 10% or less? 30 Years 1974- 2003: 12.08% 30 Years 1973-2002: 10.55% 30 Years 1927-1956: 10.06% (expecting depression as NORM?) 20% of Historical 30 Year Periods <10% 50% of Historical 30 Year Periods >10.82% 51% of Historical 30 Year Periods >10.85% (monthly data) Our CMAs: 12.32% (mean) & 18.38% SD= 10.85% Compound Our CMAs at 77 th %-tile: 8.30% at 87 th %-tile: 7.17% Worst 30 Years of History (annual data): 8.47% (1929-1958) Worst 30 Years of History (monthly data): 7.17%

23. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 23 RANDOMNESS Doesn’t Look Random! How Many Of You Think a Compound Return for Large Cap should be 10% or less? 30 Years 1974- 2003: 12.08% 30 Years 1973-2002: 10.55% 30 Years 1927-1956: 10.06% (expecting depression as NORM?) 20% of Historical 30 Year Periods <10% 50% of Historical 30 Year Periods >10.82% 51% of Historical 30 Year Periods >10.85% (monthly data) Our CMAs: 12.32% (mean) & 18.38% SD= 10.85% Compound Our CMAs at 77 th %-tile: 8.30% at 87 th %-tile: 7.17% Worst 30 Years of History (annual data): 8.47% (1929-1958) Worst 30 Years of History (monthly data): 7.17%

24. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 24 RANDOMNESS Fooling Us? Have you been fooled by?… RECENT low returns? Previously high returns (14% assumptions 5 years ago) Data sets that are too small to have any confidence in assumptions? (20-30 Years? 10 Years?) One trading discipline (MLM index) “New” asset classes (foreign stocks, mid cap, growth/value, hedge funds) “Seeing Cycles or Streaks” in Random Data? Roulette Wheel Spun 15 reds in a row! – “Red Streak” Or “Black is Overdue” (As if the ball remembers where it fell) Growth & Value “Cycle”

25. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 25 Familiar with Growth & Value Cycles? Value Outperforms Growth OutperformsHEADS TAILS Heads Tails Heads vs. Tails Random Returns Trailing 12 Flips Flip# 12 24 36 48 60 72 84 96 Heads vs.TailsRANDOMNESS? Randomness DOES NOT appear to be Random!

26. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 26 Your Advice (output) is only as good as the input … (Capital Market Assumptions) If we are going to make the most of the one life each client has, then we must: » Have comfort & confidence in achieving the goals each client VALUES » Which therefore requires avoiding undue sacrifice to their lifestyle » And would include avoiding unnecessary investment risk (risk=concern=contradiction to comfort) These are the premises of what we call: Wealthcare

27. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 27 Capital Market Assumptions SHOULD NOT CONTRADICT Wealthcare PREMISES… If we are too conservative, the price to the client’s life is: NEARLY CERTAIN UNDUE LIFESTYLE SACRIFICE REMEMBER: 1. How we were fooled by recent history? 2. How missing a few data points changed ALL the outcomes 3. How ONE YEAR of data changed the trailing returns (1.5%) 4. How reasonably large samples can be very skewed? 5. How our brains are “wired” to see streaks & cycles in random data? To avoid UNDUE SACRIFICE, we should avoid being too conservative

28. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 28 Client Desires Maximum Income and has no desire to leave more than $1 million estate: Which is Wealthcare? PRICE OF TOO CONSERVATIVE! $43,000 retirement income and 83% chance of exceeding $1 million estate with (Our CMAs): -90% chance of exceeding $450k estate? -75% chance of exceeding $1.5 million estate? OR… $24,000 retirement income, also 83% confidence but 2% lower return assumption than our CMAs: -96.5% chance of exceeding $1 million? -90% chance of exceeding $1.5 million?

29. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 29 Client Desires Maximum Income and has no desire to leave more than $1 million estate: Which is Wealthcare? PRICE OF TOO CONSERVATIVE! $43,000 retirement income and 83% chance of exceeding $1 million estate with (Our CMAs): -90% chance of exceeding $450k estate? -75% chance of exceeding $1.5 million estate? OR… $24,000 retirement income, also 83% confidence but 2% lower return assumption than our CMAs: chance of exceeding $1 million? -90% chance of exceeding $1.5 million? Being too conservative prioritizes estate above all else! With $43k income starting in 1926, they’d have an $875K estate With $24k income starting in 1926, they’d have a $2.6 million estate

30. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 30 I’d be very uncomfortable targeting low 80ish confidence with return assumptions less than ours… Nearly certain sacrifice! I’m fairly confident of our assumptions for stocks, bonds & cash because there is a lot of data to validate & test reasonableness Funny thing, a lot of the advisors that think our assumptions are “too high” (currently) or “too low” (five years ago) despite all the data, turn around and complain about our assumptions for “new classes” despite NOT having enough data to validate & test these “new classes” Isn’t a premise of Wealthcare having RATIONAL CONFIDENCE? What happens to CONFIDENCE in DELIVERING the client’s goals when we make ASSUMPTIONS about “classes” we do not have the data to validate???

31. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 31 I’d be very uncomfortable targeting low 80ish confidence with return assumptions less than ours… Nearly certain sacrifice! I’m fairly confident of our assumptions for stocks, bonds & cash because there is a lot of data to validate & test reasonableness Funny thing, a lot of the advisors that think our assumptions are “too high” (currently) or “too low” (five years ago) despite all the data, turn around and complain about our assumptions for “new classes” despite NOT having enough data to validate & test these “new classes” Isn’t a premise of Wealthcare having RATIONAL CONFIDENCE? What happens to CONFIDENCE in DELIVERING the client’s goals when we make ASSUMPTIONS about “classes” we do not have the data to validate and test reasonableness???

32. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 32 First Question Would Be…What Explains 90%+ Of The Variance Of Returns? (to see if targeted confidence is in the ballpark?) ANSWER: Asset Allocation Source: Two Studies by Brinson, Beebower & Hood Asset Allocation TO WHAT? STOCKS, BONDS & CASH LESS THAN 10% of variance was explained by small cap, midcap, growth, value, foreign, real estate, etc.

33. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 33 First Question Would Be…What Explains 90%+ Of The Variance Of Returns? (to see if targeted confidence is in the ballpark?) ANSWER: Asset Allocation Source: Two Studies by Brinson, Beebower & Hood Asset Allocation TO WHAT? STOCKS, BONDS & CASH LESS THAN 10% of variance was explained by small cap, midcap, growth, value, foreign, real estate, etc.

34. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 34 Sample Client Confidence with 100% Large Cap as Investment Policy: Based upon randomizing actual historical returns from ’26-’02 1000 times

35. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 35 How big a difference do you think it would make if the client were OVERWEIGHTED by 60% to Small Cap? Based upon randomizing actual historical returns from ’26-’02 1000 times 60% Small/40% Large 82%

36. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 36 Shouldn’t it make a HUGE difference??? It does…so long as we are planning on coin flip odds… Based upon randomizing actual historical returns from ’26-’02 1000 times 60% Small/40% Large 82% 54% 60% Small/40% Large 45% 100% Large Assuming you consider 9 pts of confidence “HUGE” near the median

37. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 37 Measuring with a micrometer…cutting with a chain saw… Would You Get Different Results With These Allocations? Asset Class#1#2#3#4 Large40%10%0%20% Large Value0%15%20%10% Large Growth0%15%20%10% Small60%0%40%10% Small Value0%30%10%25% Small Growth0%30%10%25% SHOULD YOU? THEY ARE ALL THE SAME!

38. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 38 Provided you use appropriate indices, your results would be statistical equivalents – 10 Years Ending 2002 Would You Get Different Results With These Allocations? Allocations:#1#2#3#4 Large40%10%0%20% Large Value0%15%20%10% Large Growth0%15%20%10% Small60%0%40%10% Small Value0%30%10%25% Small Growth0%30%10%25% Mean9.469.359.399.37 Compound8.228.138.168.15 Standard Deviation16.5916.4616.5216.49 Sample Confidence49%48%48%48% Are we getting better assumptions by slicing the pie into more pieces?

39. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 39 Or are we increasing our estimation error by limiting our data set? Would You Get Different Results With These Allocations? Allocation:#1#2#3#4 11 Years 2003: Mean10.6210.5710.6310.58 Compound9.459.419.469.42 Standard Deviation16.2116.1416.2016.14 Sample Confidence64%63%64%63% 10 Years 2002: Mean9.469.359.399.37 Compound8.228.138.168.15 Standard Deviation16.5916.4616.5216.49 Sample Confidence49%48%48%48% Since the results are statistically the same between the allocations…

40. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 40 Would You Get Different Results With These Allocations? Allocation:#1#2#3#4 11 Years 2003: 11 Years 2003 Mean:10.6210.5710.6310.58 Sample Confidence64%63%64%63% 10 Years 2002: Mean9.469.359.399.37 Compound8.228.138.168.15 Standard Deviation16.5916.4616.5216.49 Sample Confidence49%48%48%48% Since the results are statistically the same between the allocations… 25 Years 2000:18.13% Sample Confidence99% Which “Error” Reduces My OVERALL Confidence More? Ignoring Subclasses?

41. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 41 Would You Get Different Results With These Allocations? Allocation:#1#2#3#4 11 Years 2003: 11 Year 2003 Mean:10.6210.5710.6310.58 Sample Confidence64%63%64%63% 10 Year 2002: Mean9.469.359.399.37 Compound8.228.138.168.15 Standard Deviation16.5916.4616.5216.49 Sample Confidence49%48%48%48% Since the results are statistically the same between the allocations… 25 Year Mean 2000:18.13% Sample Confidence99% Which “Error” Reduces My OVERALL Confidence More? Ignoring Subclasses? +/- 1% Or ignoring the effect of limiting my sample population so I can include Sub- Classes? +/- 50% +/- 15% +/- 35%

42. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 42 Making assumptions from limited data, usually has the opposite effect of excessive conservatism Instead of nearly certain sacrifice… We MIGHT be subjecting the client to: TOO MUCH UNCERTAINTY

43. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 43 Making assumptions from limited data, usually has the opposite effect of excessive conservatism Instead of nearly certain sacrifice… We MIGHT be subjecting the client to: TOO MUCH UNCERTAINTY If the effect of “new classes” on the overall portfolio is 1-2% standard deviation and/or 50-100 bps of return… You could very well be assuming the value of the “new” class is the same a moving the 50 th %-tile to the comfort zone! HOW CAN YOU ASSUME THAT?!

44. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 44 Making assumptions from limited data, usually has the opposite effect of excessive conservatism Instead of nearly certain sacrifice… We MIGHT be subjecting the client to: TOO MUCH UNCERTAINTY If the effect of “new classes” on the overall portfolio is 1-2% standard deviation and/or 50-100 bps of return… You could very well be assuming the value of the “new” class is the same a moving the 50 th %-tile to the comfort zone! HOW CAN YOU ASSUME THAT?! The best evidence your assumptions are wrong about a class, come from Mean Variance Optimizers…

45. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 45 If the results of an MVO are “Wacky” And you obviously need to constrain it because it shows: Everyone holding stocks (we have good data) is stupid But should own managed futures or hedge funds (we have little data) and is therefore “enlightened” There is probably a stupid assumption in there somewhere… But Dave, isn’t that why optimizers have constraint inputs? A lesson in Algebra…

46. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 46 The output is only as good as the input … (Capital Market Assumptions) If you get wacky unconstrained allocations, IT MEANS YOUR INPUTS ARE WRONG! If you have to constrain your optimizer to avoid “wacky” results, YOUR INPUTS ARE WRONG! A lesson in Algebra… Solve this equation: 4 x =4 x =1

47. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 47 Now, solve our simple equation but constrain x to be < or = to.5 (just like an optimizer constraint) If you have to constrain your optimizer to avoid “wacky” results, YOUR INPUTS ARE WRONG! A lesson in Algebra… Solve this equation: 4 x =44 x =4 x =1If x is < or = to.5 then x =.5 OR2=4 A lesson in Algebra… Solve this equation: 4 x =44 x =4 x =1If x is < or = to.5 then x =.5 OR2=4 The output is only as good as the input … (Capital Market Assumptions)

48. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 48 Now, solve our simple equation but constrain x to be < or = to.5 (just like an optimizer constraint) If you have to constrain your optimizer to avoid “wacky” results, YOUR INPUTS ARE WRONG! A lesson in Algebra… Solve this equation: 4 x =44 x =4 x =1If x is < or = to.5 then x =.5 OR2=4 A lesson in Algebra… Solve this equation: 4 x =44 x =4 x =1If x is < or = to.5 then x =.5 OR2=4 The output is only as good as the input … (Capital Market Assumptions) ANY constrained allocation is as silly as saying 2=4!

49. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 49 Finally, What About Forecasts? Mean Reversion? Forecasts (mean reversion is just a forecast by another name) do not mix well with measuring confidence in random outcomes. This is not to say you are unskilled at forecasting… But, what is the confidence level measuring if it was based on a distribution created by a forecast? Long Term Nature of Market Worst of History Best of History Median 10.85%

50. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 50 Finally, What About Forecasts? Mean Reversion? Forecasts (mean reversion is just a forecast by another name) do not mix well with measuring confidence in random outcomes. This is not to say you are unskilled at forecasting… But, what is the confidence level measuring if it was based on a distribution created by a forecast? Long Term Nature of Market Worst of History Best of History Median 10.85% Best of history near “norm”?

51. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 51 Finally, What About Forecasts? Mean Reversion? Forecasts (mean reversion is just a forecast by another name) do not mix well with measuring confidence in random outcomes. This is not to say you are unskilled at forecasting… But, what is the confidence level measuring if it was based on a distribution created by a forecast? Long Term Nature of Market Worst of History Best of History Median 10.85% Best of history near “norm”? Worst of history near “norm”? Effect of +/- 2.5%

52. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 52 Which mean are we reverting to? Market Returns Ending in 2003: 5 Years, bottom 10%-tile of all 5 year periods » Raise Assumption? 10 Years, 51 st %-tile of all 10 year periods » Keep the Same Assumption? 25 Years, top 16%-tile of all 25 year periods » Lower Assumption?

53. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 53 So, how can we be confident about our CMAs for all the asset classes??? WE CAN’T!!! But… The “main driver” is stocks, bonds and cash There we have a lot of good data We have reasonable confidence in the assumptions And it is how we invest Other classes with less evidence cannot by definition do anything other than introduce more uncertainty (risk) Isn’t Wealthcare about avoiding unnecessary risk?

54. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 54 How our assumptions are built… For classes with a lot of good data (i.e. domestic stocks, bonds & cash) Risk & Return= Average of 700+ 10 year periods Correlations based on all historical data Tested in engine (30,000 simulated years vs. 76 years of history) Extremes of simulations wider than history (based on SD) Middle of simulated distribution near middle of historical data For other assets… If possible, use a proxy (i.e. foreign stocks are still stocks) Adjust for added uncertainty (i.e. currency risk for foreign, limited data for alternative classes) Use correlations but test with a Cholesky decomposition Perform MVO test (i.e. adjust as needed to avoid excessive assumed alpha but still shows some incremental value)

55. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 55 How our assumptions are built… For classes with a lot of good data (i.e. domestic stocks, bonds & cash) Risk & Return= Average of 700+ 10 year periods Correlations based on all historical data Tested in engine (30,000 simulated years vs. 76 years of history) Extremes of simulations wider than history (based on SD) Middle of simulated distribution near middle of historical data For other assets… If possible, use a proxy (i.e. foreign stocks are still stocks) Adjust for added uncertainty (i.e. currency risk for foreign, limited data for alternative classes) Use correlations but test with a Cholesky decomposition Perform MVO test (i.e. adjust as needed to avoid excessive assumed alpha but still shows some incremental value)

56. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 56 In summary… If we are really providing: Confidence in exceeding goals, without undue sacrifice or unnecessary risk… We cannot bet our clients’ future, or worse, misrepresent the confidence level based on: » Skewed data » Lack of evidence » Hope or Prophesies… » These all contradict the premises of Wealthcare

57. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 57 In summary… If we are really providing: Confidence in exceeding goals, without undue sacrifice or unnecessary risk… We cannot bet our clients’ future, or worse, misrepresent the confidence level based on: » Skewed data » Lack of evidence » Hope or Prophesies… » These all contradict the premises of Wealthcare

58. ©Copyright Wealthcare Capital Management, a division of Financeware, Inc. 2004 All rights reserved P r o v i d i n g W E A L T H C A R E PAGE 58 Questions?