 Performance standard deviation: measuring investment volatility (not risk!)

March 15, 2014 by Editor, InvestingForMe

This week marked the deadline for public submissions to the Canadian Securities Administrators (CSA) as it develops new guidelines for its mutual fund risk classification system. Specifically the CSA is proposing that each mutual fund manager be required to calculate the volatility of their mutual fund’s past investment performance in the form of its performance standard deviation and that calculated number will be used by the fund’s managers to classify the fund’s risk rating. That risk rating is to then be published on the fund’s Fund Facts form for investors.

Investment volatility vs. risk: let’s separate the two

Unfortunately the CSA change may actually end up creating more confusion than clarity as investors simply assume that an investment’s performance volatility is a measure of an investment’s risk – which it’s not!

Assessing the risks inherent in an investment is more complex than simply calculating a statistic around the ups and downs in the investment’s performance. So a supposedly new helpful guideline by the CSA telling investors that performance volatility equals investment risk is not really all that helpful. The two are actually quite different, and unfortunately what we have here is a great example of Penguin Logic at work. What we all need to remember is this: an investment’s performance standard deviation is a statistical statement about the historical changes of an investment’s market performance or volatility. And while this number may reflect an element of investment risk, by no means is it a surrogate measure for an investment’s overall risk!

In other words, equating performance standard deviation with investment risk is an over-simplification. And to better understand why, we first need to understand performance standard deviations and what they actually measure.

Performance standard deviation: definition

So, let’s say your looking for a new investment for your recent RRSP contribution and you find an investment that looks like a good one. Your research reveals that it has earned an average annual return of 7.0% for the past 10 years. And just like most of us, your brain looks at that number and automatically assumes this will be your annual return for the next 10 years. Right? So you go ahead and buy it.

But lo and behold this great investment actually loses you 4% in the 1st year and then another 4% in the next. Huh? What happened to that 7% sure thing?

Well, this is where that investment’s performance standard deviation might have helped you to better understand the investments performance volatility. After all, most investors understand that an investment can be up one year (say, up 17%) and down the next 2 (say, -4% and -4%) and still have a positive average annual return (+3%), right? But if you had known the investment’s performance standard deviation number, you could make a more informed investment decision, and your expectations for the investment’s performance down the road might have been different.

Remember: Standard deviation, when applied to investment performance, is an easy way to measure how much an investment’s rate of return varies, above and below, from its average and it may be an indication of how much volatility you should expect in the future.

How it’s measured

The concept of standard deviation is measured in units referred to as standard deviations – one standard deviation, two standard deviations and three standard deviations, where

• one standard deviation above and below the average number will capture 68% of all the possible outcomes
• two deviations above and below the average number will capture 95% of all possible outcomes, and
• three standard deviations, above and below, the average number will capture 99.7% of all possible outcomes

And to make it easier to understand and use, standard deviation is expressed in the same units as the data being analyzed, in our case percentage, and it may simply be presented as a single number with a “+” and “–“ sign in front of it. Or it might be presented as a single number, assuming the reader understands the standard deviation is to be added and subtracted from the average.

Example

So when you read about that investment returned 7% every year for the past 10 years, you might think it sounds great but you really don’t have the full story as we illustrated earlier. However, if that 7% average annual performance number also had a standard deviation of + or – 20%, you would know, more or less, how it performed in the past and what to expect in the future, with fewer surprises!

Specifically, you would know that a 7% investment with a performance standard deviation of + or – 20%, is the same way of saying the investment has had an average annual return equal to 7%, but where

• 68% of the time (one standard deviation) the investment’s annual return was somewhere between up +27% (7% + 20%) and down -13% (7%-20%), and
• 95% of the time (two standard deviations) the investment’s annual return was somewhere between up +47% (7% +20%+20%) and down -33% (7%-20%-20%).

In other words, if you know and understand an investment’s performance standard deviation then you’ll have a better idea how much the value of your savings might go up and down when you make that next buy!

One final note: less is more …

As you can see from our discussion, an investment’s performance standard deviation is nothing more than a statistical comment or observation on the historical ups and downs of an investment’s annual performance. It does not, however, capture the risks that are inherent in the investment nor the markets that influence the investment’s actual performance.

With a better understanding of an investment’s performance standard deviations, you should have greater confidence in using them when deciding which investments are best suited for your savings.

So, just be careful the next time you see an investment fund’s Fund Facts risk rating. Remember that the rating will be based upon the fund’s performance standard deviation but this will not contain the full story of its risk factor! (Note to self – Penguin Logic at work…)

Next time I’ll delve into how you can use the three main causes of investment underperformance to your advantage. (Hint: Performance standard deviation is one of them.)