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The Process that Makes K4 Decisions Tools so Unique
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Like all choices, investment decisions involve compromises among conflicting goals and outcomes. We expect high return, but we also want low risk. We know we’ll need to save a substantial sum for retirement, but we really need our cash flow now. Although we know we should focus on the long-term, we’re often tempted to act based on short-term developments. As we all realize, our investment decisions are ultimately shaped by the way we resolve these conflicts.
This is not much of a problem when we’re confronted with only two choices. It may take some thought, but we can usually decide which is more important and act accordingly. Unfortunately, investment decisions usually aren’t that easy, and typically involve more than two conflicting factors. Consider, for example, a worker saving for retirement. He has to balance his current savings rate (which inversely affects his current spendable income) with the amount needed to provide a comfortable income to last throughout retirement. He also needs to balance the need for investment growth with his level of risk aversion. The entire plan has to come together by the time he plans to retire or he will have to work longer. Is he willing to do that to save less now? Does he want to invest more aggressively so he can save less or retire sooner? Can he stomach the increased risk and stay the course?
Then, consider the investment advisor seeking the appropriate managers or mutual funds for her clients. She wants them to invest for the long-term, but she also realizes her clients will evaluate results in a much shorter time frame. She needs to assess the risk as well as the consistency for all the alternatives. To top it all off, the importance of each factor differs from client to client and she needs a way to include that in the decision.
Both of these examples illustrate the complexity of even the most fundamental investment decisions. Both are a far cry from a simple choice between two alternatives, and both require compromises among a number of conflicting issues. This is certainly not an insurmountable task; we do it everyday. Where we often fail however, is in doing it confidently, efficiently, and well.
Assumptions and Iterations
The decision process typically goes like this:
- Select the factors that are important to the decisions.
- Assign values to elements you can estimate
- Solve for one you can't
- Review the results – if not satisfactory, change the assumptions in Step 2 and repeat the process until they are okay or until there is no more time available
In our examples, the future retiree may be willing to work until age 65, needs $50,000 a year in retirement, expects to live to age 90, and feels he can safely earn 8% per year on his savings while working and 6% per year after retirement. He can then solve for the savings rate necessary to achieve his objective. The investment manager may want all of her funds or managers to have 1 and 5-year returns in the top 5% of their peer groups, below average standard deviation, a positive alpha, and r-squared greater than 0.8 to the benchmark index. This will provide a list of managers and funds meeting all criteria.
The final step of the process is to review the results. If the future retiree is satisfied with the suggested savings rate, he can implement his plan. If he thinks he can’t afford to put aside that much now (or if he feels he could comfortably save more) he can adjust his earlier assumptions (e.g. he could retire at a different age, use a different expected return by adjusting the aggressiveness of his investments, etc.) He can repeat this process again and again until he arrives at a result that he is willing to accept. The same holds true for the investment advisor. If not satisfied with the initial results, she can adjust the limits on her various screens until she gets a list of managers and funds she could confidently recommend to her clients.
There are tools available to help in both instances. Retirement savings calculators are readily available via the Web as stand-alone software or even as simple paper-based questionnaires. Investment screening tools are also available from a number of different sources. These tools will help with the process and you will eventually reach an acceptable result, given enough time. However, the iterative nature of the process is inefficient, it won’t necessarily yield the optimal result and even if it does, the user has no way of knowing it.
The basic problem lies not with the tools but with the approach. Rather than solving for the optimal combination of all factors, it relies on setting acceptable levels for some and then solving for another. In order to reach even that result, the user has to create and enter various combinations of inputs, all of which may be more or less acceptable. The solution may work, but without enduring numerous iterations there is no way to know if there was another combination of factors that would have yielded greater overall satisfaction. To get this result, you need an approach that will truly solve for the highest degree of satisfaction for all factors simultaneously. This is precisely what the K4 Decision Tools are designed to do.
One Solution, No IterationsThe patented K4 Process is the basis for each of the K4 Decision Tools. It utilizes a widely accepted statistical methodology know as “conjoint analysis” to measure investor preferences, resolve trade-offs, and produce a single, complete, ranked solution set. By solving for multiple variables in a single step, the K4 Process enables the user to reach a superior, definitive solution in less time without the need for trial and error. Not only that, the user is assured it is the optimal solution.
Conjoint analysis has been successfully used in the field of marketing research since the late 1970s and has been considered a mainstream technique for assessing consumer preferences for over 15 years. Klein Decisions has an exclusive license to use this patented process in its investment decision tools. The K4 Process guides the user to assign importance weights for different attributes of an investment decision, resolves inherent conflicts, and produces a comprehensive ranked solution set for all variables. This is accomplished through five basic steps:
- Select the factors that are important to the decision
- Rank the importance of each factor independently of the others
- Choose the level of importance between two factors at a time
- Solve for the highest level of satisfaction on all factors simultaneously
- Review the complete rank-ordered solution set
With the K4 Process there is no need for additional iterations. Its complete solution set rank orders all alternatives so the user sees all options and more importantly, knows that the top-ranked solution best matches his or her preferences across all factors.
Klein Decisions has developed four applications of the K4 process in four decision tools- K4 Fund Selection, K4 Manager Selection, K4 Portfolio Selection and K4 Plan Goals. Going back to the earlier examples and using K4 Decision Tools for the decision, K4 Plan Goals would not require the future retiree to set specific estimates for any of the factors. Instead, it would present a series of questions asking him to rank the importance of each. Next, based on those responses, it would ask him to choose his level of preference between two factors at a time. Like that simple decision discussed earlier, he never has to choose between more than two options at a time, yet this is enough to enable K4 Plan Goals to generate a ranked order of alternatives with varying degrees of satisfaction across all factors- retirement age, savings rate, investment portfolio, and retirement income. The top ranked option offers him the highest level of satisfaction in this decision across all factors. There is no need for additional iterations.
Similarly, K4 Manager Selection and K4 Fund Selection employ these steps in ranking investment managers and mutual funds, respectively. The advisor selects the factors to use in the evaluation, ranks the importance of each, chooses her level of preference between two at a time, and then receives a rank-ordered list of the products based on her preferences across all factors simultaneously. Again, there is no need for additional iterations, no need to adjust screens to get an acceptable answer, and no need to choose subjectively between the remaining multiple alternatives.
It is the K4 Process that enables the K4 Investment Decision Tools to yield concise, complete, and definitive results. Further iterations are not needed because it gives you the complete solution set. No time is wasted with additional iterations. The user is not left wondering if all possible alternatives have been considered. Not only are all options presented, they are rank ordered based on the user’s unique preferences. As they say on the game show, it is the “final answer” and this is the unique value-added proposition of all the K4 Investment Decision Tools.