Download Two standard deviations = 95% of annual returns

Investment
Risk
International Investment Risk
Small Capitalization Equity Risk
Sector Risk
Inflation Risk
Manager Risk
Market Risk
Currency Risk
Credit Risk
Liquidity Risk
Interest Rate Risk
Securities Lending Risk
Income Trust Risk
Derivative Risk
Substantial Security Holder Risk
What level of risk are you comfortable with?
• Low risk
• Moderate risk
• High risk
What does it mean?
Advisor
Interpretation
Client
Interpretation
Gap
What maximum drop in value over a one-year period
are you comfortable with?
• 0%
• -15%
• -5%
• -20%
• -10%
• Other
You, as well as your clients, will now know how big of a
drop in value they can accept.
How can you determine which funds respect
your clients’ risk tolerance?
By using the standard deviation and the
mean return.
• Measure of variance that defines the risk of an
investment by indicating by how much the actual
return has varied from the mean return.
• The higher the standard deviation, the higher the
volatility. For example:
•
•
•
•
Money Market Fund
Fixed Income Fund
Balanced Fund
Canadian Equity Fund
0,05
2,93
7,11
11,87
• How can you tell if the standard deviation is too high
for a client?
• We need to know what is the mean return.
Mean return
What maximum drop in value over a one-year period
are you comfortable with?
• 0%
• -15%
• -5%
• -20%
• -10%
• Other
One standard deviation =
68% of annual returns
(approx. 2 years out of 3)
Two standard deviations =
95% of annual returns
(approx. 19 years out of
20)
Investment
Mean
Return
Standard
Deviation
A
4.0%
5.0%
-1.0%
9.0%
-6.0%
14.0%
B
6.0%
10.0%
-4.0%
16.0%
-14.0%
26.0%
C
8.5%
15.0%
-6.5%
23.5%
-21.5%
38.5%
D
10.0%
20.0%
-10.0%
30.0%
-30.0%
50.0%
Source: « La relation entre risque et rendement », Objectif Conseiller, juin 2010
Standard
deviation last 5
years
Average of
rolling oneyear returns
for the last 5
years
3.07
Growth &
Income
Monthly
Income
Funds
Fixed Income
Canadian Small
Cap.
Minimum and maximum annual
return based on 2 standard
deviations (95% of the data)
Minimum
Maximum
4.96
-1.18
11.10
12.15
-1.03
-25.33
23.27
9.25
5.20
-13.30
23.70
22.85
8.29
-37.41
53.99
Standard
deviation last
10 years
Average of
rolling oneyear returns
for the last 10
years
Fixed Income
3.23
Growth &
Income
Funds
Canadian Small
Cap.
Minimum and maximum annual
return based on 2 standard
deviations (95% of the data)
Minimum
Maximum
4.00
-2.46
10.46
9.63
4.94
-14.32
24.20
18.02
13.95
-22.09
49.99
Source: PalTrak, Morningstar Canada
Such information is available on company
websites or on public sites such as
www.globefund.com
Two funds in the same category with similar
volatility but a different return.
Global Fund
Global Dividend Fund
Two funds from different categories with a similar
past performance but a different volatility level.
Balanced Growth Fund
Canadian Small Cap. Fund
• The use of the standard deviation and mean return
helps in the selection of appropriate funds with
regards to a client’s risk tolerance.
• Gives the clients a clearer picture of the potential
drops in value and helps prevent selecting
investment options that exceed their risk tolerance.
• We recommend that you use at least two standard
deviations in your analysis.
• Past performance may not repeat itself.
• In reality, the distribution of rolling one-year returns
do not follow a normal distribution.
Possibility of losing money
Possibility of not reaching their financial
objective
Objective
Objective
not attained
Starting
Point
Investor’s Risk
Tolerance
Investor’s Goal
To reach the
goal at a
specific date,
the annual
return must be
7%.
GAP
The fund that
matches the
client’s risk
tolerance has an
expected annual
return of 4%.
You should address the gap before making an investment
recommendation.
S
T
E
W
• Save more
• Take less (smaller goal)
• Earn more (return)
• Wait (reach goal later)
• What does your client prefer?
• A combination of these solutions can be applied.
EMOTIONS
They don’t mix well!
“I should get
in now!”
Excitement
Denial
Hope
Optimism
Anxiety
Panic!
“I’m getting
out!”
Source: Bloomberg
The Terrance Odean study
Group A
Most frequent
transactions
Group B
On average, Group A
underperformed Group E by 7%
per year.
Group C
Group D
Group E
Less frequent
transactions
PROCRASTINATION
A story about two investors…
Similarities
• Average annual return of 6.00%
• Total amount invested over time: $36,000
Differences
• Investor A:
– Investment period from age 30 to age 60
– Monthly investment = $100
• Investor B:
– Investment period from age 45 to age 60
– Monthly investment = $200
A) - Both investors end up with the same market value at age 60.
B) - Investor A will have more money at age 60 than investor B.
C) - Investor A will have more money at age 60 than investor B.
The Big Difference
• Investor A:
– Market value at age 60 = $100,451.50
• Investor B:
– Market value at age 60 = $58,163.74
– To get the same end result as his friend,
Investor B would have to invest $345.41
per month for a total of $62,173.80
Another example with a 6% annual return
Investor A
Investor B
From age 30 to 45
From age 45 to 60
$200.00
$200.00
Total Investment
$36,000.00
$36,000.00
Market Value at 60
$139,392.79
$58,163.75$
---
$479.31
Investment Period
Monthly Investment
Required Investment to
Match Investor A
INFLATION
• The more the goal is long-term, the more impact inflation will have
in the plan to reach that goal.
• For retirement plans, since retirement can last many years, inflation
can have a devastating effect if it wasn’t taken into account in the
plan.
Source: Viewpoint, Lifetime income planning, Fidelity Investments
Index
1 year
3 years
5 years
10 years
FTSE TMX 91 day
Treasury Bill Index
0.5%
0.8%
0.9%
1.6%
*As of June 30, 2016
• It is true that “secure” investments such as shown in the table above do not have
market risk and very low, or no, volatility (i.e. negative returns).
• However, if the investment return is lower than the inflation rate, it results in a
negative net return.
• Inflation is a type of risk that must be accounted for when determining an
investment strategy to reach a financial goal.
• There are many investment risks: some technical,
others behavioural in nature.
• It is important to clearly establish clients’ risk
tolerance before recommending and implementing
an investment strategy.
• Determine if there is a gap between the risk
tolerance and the financial goal and help clients
make choices that will eliminate this gap.