“Gamma” – The New Measure of Good Financial AdviceBy Hans Egger | July 18, 2016
Defining good financial advice can be difficult. Too often, clients believe that a good return on their investment relates to good advice, and too often financial planners perpetuate this myth.
We’ve long understood that “Beta” represents systemic risk exposure (represented by the market), of a balanced versus a high growth asset allocation, and “Alpha” represents the excess returns that have been achieved (through the choice of underlying investments) in the portfolio.
Financial planners who focus on Alpha and Beta when discussing investments are missing the point of their profession and setting themselves up for failure. Let’s face it: Robo-Advice can determine a risk profile through a set of questions and then provide a model portfolio. The Modern Adviser understands that “Gamma” is the true measure of good financial advice. David Blanchett and Paul Kaplan of Morningstar who coined the term in their journal article Alpha, Beta and Now…..Gamma, described “Gamma” as the additional value achieved by an individual investor from making more intelligent financial planning decisions”.
This is where financial planners’ with their years of study and experience can make a real difference to their clients. Let’s look at an investor; Bob is 50 years of age, has $300,000 in superannuation, earns $100,000 pa. (plus super) and has savings of $6,000 per annum. Bob is happy with a balanced investment portfolio, expecting a return of 7.6% pa over the long term, as he builds wealth for his retirement at age 65. The decision Bob makes regarding the use of his $6,000 in savings each year for the next 15 years can have a huge impact on his wealth creation:
- If Bob decides to use the $6,000 (after tax) to reduce his mortgage then he will create $120,537 in wealth.
- If Bob chooses to salary sacrifice the $6,000 (pre-tax $9,836) to his super fund (expecting 7.6% p.a. return) then he would expect to create wealth of $167,002
So in this example the Gamma impact of making the salary sacrifice decision is approximately $46,465 over 15 years.
- If Bob decides to take option 2 and at age 60 implement a Transition to Retirement Strategy
- maximising his deductible contribution
- draws the same income as he currently earns, and
- uses any surplus pension to reduce his mortgage
- Then he will create $499,751 in wealth
So in this example the Gamma is an amazing $379,214 compared to the first option. The challenge for financial planners is how to identify these strategies and then explain them in such a way that the client understands not just the end benefit but also the underlying reasons for the benefit so that they can make an informed decision. Through the use of real time modelling software this is now not such a difficult task.
The Modern Adviser positions their value proposition around these controllable Gamma benefits and educates their clients that the fluctuations of the markets are simply background noise once the strategy has been set.
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