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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.