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WHICH RISK MEASURES TO USE
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THE KNOWLEDGE BANK
David West is a veteran financial adviser, journalist, and teacher. He covers the waterfront on the nuts and bolts of investing in mutual funds and ETFs.



By David West  | Wednesday, July 07, 2010


As a lead-in to today’s topic, let me start off with two conclusions. First, most investors spend way too much time doing certain things, and way too little time doing others. Second, most investors make only very average returns on their portfolios. Perhaps the two are related?

On the second point, sure, some investors make very good money with their portfolios. However, these are very few in number. Most investors make modest and average returns over time, even if they claim otherwise.

On the first point, I’ll give you an example of investors spending disproportionate times on their investing activities. One of the readings that made up part of the Chartered Financial Analyst program years ago when I took it determined that investors spent far more time making their buy decisions than their sell decisions.

They concluded that investors who better balanced the times spent making both decisions generated statistically-significant superior returns on their portfolios.

I’d take that point further, and propose that there are lots of things we can see average investors doing disproportionately, and by not doing that ourselves, we may be putting ourselves in a position to improve our returns.

There is probably no bigger distortion in investing than the so-called “risk-return” equation. Its two components – risk and return – are equal players in a symbiotic relationship. One is just as important as the other.

Yet you know the reality on the street. Propose something to a potential investor, and 99 times out of 100 their first question will be about how much they can make on it. You have to move up the investor sophistication level before risk even becomes part of the conversation.

There it is. You know the common investor has this predilection, and you know it probably costs him or her potential returns. So what’s your next step?

How about this? You resolve to not make that same error. You resolve to learn a little more about risk, and to start incorporating risk more into your investment decisions.

Great! So let me help you with the “learning about risk” part. The Fund Library offers you a number of options to filter funds by risk category, including three-year standard deviation and three-year beta.

Which should you use, in your new commitment to incorporate risk more into your investment decisions? (And no, you don’t use both.) It depends on the type of investor you are. If you are a passive, buy-and-hold, broadly diversified investor, you should probably be using beta as your risk measure. If you’re an active, sector-rotating, market timing type of investor, standard deviation is the measure you want to use.

It’s all in how they’re calculated in the first place. “Beta” measures the volatility of a single investment relative to the volatility of the overall market, on a scale where the market’s volatility is 1.0, and the individual investment’s volatility is the same, of half, or double, that of the market.

“Standard deviation,” on the other hand, measures the investment’s short-term potential volatility relative to the long-term expected return of that same investment. Standard deviation is measured in percentage terms, and indicates, for example, that in any one typical year, that investment’s expected return could be higher or lower by the indicated percentage.

So if you’re going to incorporate risk more into your investment decision making, it’s a good first step to make sure you choose which risk measure is the right one for you.

David West, CFA, FCSI, has more than 25 years’ experience in the financial services industry as an adviser, trainer, writer and commentator. He is a columnist for The MoneyLetter and Canadian Business Online among others, and is a regular contributor to the Fund Library.

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Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

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The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.

 
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