Even Leicester’s most ardent fans may have been hard pressed to predict this outcome, given that just under a year ago Leicester were languishing near the bottom of the table.
However, as Leicester’s success has shown us, relying on past performance, whether good or bad, is not exactly the best method of forecasting football results. The same can also be said when it comes to financial planning and forecasting the level of returns on our investments.
Stochastic Asset Models
More than ever, financial models are being used to assist individuals both in making financial decisions and helping them to evaluate the potential outcomes from different financial strategies.
Stochastic models, a method for predicting outcomes that involve a certain degree of randomness, or unpredictability, not only determine which outcomes are expected to happen but also show those which are less likely to occur. Such models are used for a wide range of purposes but are particularly effective at illustrating the trade-off between investment risk and reward.
However, not all kinds of stochastic models give a realistic view of future investment returns. The two main types of models used in the market today are mean / variance / covariance asset models (MVC), and economic scenario generators (ESG), such as that provided by EValue.
MVC models are based on the assumption that past performance and variability can be used to predict the future. The quality of an MVC model is, therefore, significantly influenced by the time period over which investment performance is measured.
However, choosing a period that is too long, too short, or is a different period across different asset classes will lead to flawed and unrealistic results. Too short a period may not give a true indication of performance over the long term and choosing too long a period may include certain factors which are no longer relevant.
MVC models also take no account of how long an investment is held for. Such models assume the same average return irrespective of the term of the investment. In reality, the risk and return characteristics of assets will vary greatly depending on the investment term.
In contrast, EValue’s ESG model does not depend on historic performance and can therefore forecast investment returns on a more realistic basis. EValue’s model has been designed to reproduce the fundamental real life characteristics of assets thereby enabling sensible and realistic forecasts to be produced.
In short, a good stochastic model provides a robust mechanism for linking investment risk and the associated returns in a way which is not dependent on a specific period of historic investment data.
Following Cruyff’s tika-taka football revolution at Barcelona in the early 1990s, a new era of counter attacking football has recently brought the antiquated 4-4-2 formation back into fashion. Leicester, in particular, have thrived in this rekindled direct approach environment thanks to their incredible speed on the break enabling players to be unleashed forward into attack.
Asset models also need to evolve in order to continue to be successful and remain relevant.
Changing economic circumstances, greater availability of data, technical developments and improvements in computational efficiency will ultimately require adjustments to be made to even the best forward-looking asset models.
On closer inspection, it would appear that football management and investment portfolio management may have more in common than initially thought. Perhaps, therefore, when it comes to financial planning, prospective investors should consider giving Claudio Ranieri a call?
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