Last week we spent some time talking about the differences between how the industry defines risk and how the investor defines risk. This week, I would like to tackle some of the different ways to measure and quantify risk.
- Standard deviation. The investment industry's primary measure of risk is standard deviation. Standard deviation really tells you how much an investment will fluctuate from the average return. For example, if Bell Charts (by Morningstar) says that a fund has a standard deviation of 3.0, this means that the monthly return will be 3% lower than the average monthly return and 3% higher than the monthly return. If the average monthly return is 2%, then the range at a 3.0% deviation is -1% to 5% (statistically, this happens with a 68% likelihood).
- Chance of loss. Chance of loss measures how often a fund loses money versus makes money. Ultra-conservative investments make money 100% of the time and never lose. At the other extreme, some Far East funds lose money as much as 60% of the time and make money only 40% of the time. The more often a fund loses money, the greater the patience required by the investor.
- The magnitude of loss. When an investment loses money, how much could a fund lose in any given year? Measuring this will tell us the tolerance we have for loss. Suppose a fund loses as much as 40% in any given year. That means a $100,000 investment becomes $60,000. More conservative funds might only drop 10%, a level much more tolerable to many, especially nervous, investors. Bell Charts (by Morningstar) uses a figure called worst 1-year return to measure the magnitude of loss.
- Draw down. According to Levi Folk of Fundlibrary.com, “A draw down is the loss incurred in a fund from any high point in the fund's value until the fund recovers that value.” Drawdowns are typically expressed as a percentage from a previous high. For example, the maximum draw down for the AIC Advantage Fund was -37% and occurred March of 2003. Fundlibrary.com has an incredible tool that helps investors understand draw downs of various mutual funds.
- Beta ratios. Beta ratios are used to measure the risk of an investment relative to the risk of a comparable market benchmark. If we look at the Canadian Equity Funds, the Mackenzie Ivy Canadian Fund has one of the lowest Betas at 0.36. On the other end of the spectrum, the Mavrix Growth fund has the highest beta at 2.00. What do these numbers mean? If a fund has a beta of 1.0, it is said to have the same risk as the market. Thus, the Mavrix Growth Fund with a beta of 2.0 is said to have twice the risk of the market. The Mackenzie Ivy Canadian, with a beta of 0.36 is said to have one-third the risk of the market. Betas are often used in the industry as a relative benchmark for risk analysis.
In a nutshell
So there you have five good measurements of risk. Which one is best to use? The answer is it is always better to use more than one measure to analyze risk. The challenge that any investor will have is finding this type of information.
The reality of our industry is that finding performance data is easy. Go to any publication, any website and you will find annualized returns, calendar returns, and short-term returns. You can find the best and worst lists for different time periods and it will be based on performance and returns.
Then go on the hunt for standard deviations, betas, draw downs and loss information and you will find that you become more frustrated. Yet understanding risk is one of the most important aspects to analyze when picking an investment. Despite the hurdles, the information is out there. www.fundlibrary.com has comprehensive draw down information. Standard deviation can be found on any of the mutual fund websites. Loss information can be found if you subscribe to Morningstar's Bell Charts software program.
I've always said that it is risk that determines performance. You need to take the time to understand risk, find ways to quantify risk and then match the appropriate investments to your personal risk tolerance. Any investor that takes the time to go through these steps will be more comfortable with the investment choices they make.