Investors Shun Risk

A relationship exists between investment risk and expected return.

The safer the asset, the lower the expected return. The greater the investment risk, the higher the required return. Or it can be a tad more technical if you like.

Investors should take an objective view of investment risk. Unfortunately, investors tend to be emotional creatures and these volatile times lead people to become fearful of investment risk.

So what is happening? And what should you do as an investor?

Investors Shun Risk

According to Morningstar, Shaken Investors Shun Risk.

The demographic bulge of aging baby boomers is becoming ever more risk-averse as it continues its march toward retirement. At the same time, investors as a whole have become financially and emotionally scarred by bear markets. The result, says financial-services consultant Goshka Folda, has been a flight to safety.

The first sentence makes sense. Younger investors have a significant time horizon. Young investors have more time to ride out the increased volatility of higher risk assets. As such, young investors should seek out relatively higher risk assets to reap higher expected returns.

As investors approach retirement, there is less time available to deal with highly volatile investments. Safety and certainty are more important. That is why you see older investors shift their capital into lower risk asset classes. And receive lower returns.

The second sentence though, reflects how emotions play a significant role with investors. Emotions should be avoided when investing. That said, I realize how hard it is to maintain a disciplined, unemotional, investment strategy when markets are moving like a roller coaster.

How This Impacts Asset Allocations

Of the more than $3 trillion in investible assets of financial wealth, more than $1 trillion is sitting in deposits (Source: Household Balance Sheet Report, 2011 Edition). In addition, close to another $1 trillion consists of short-term instruments with maturities of less than one year.

A lot of investors appear to be heavily invested in low-risk, low-return assets.

While this low risk approach might be reasonable for retirees (but beware that a 65 year old retiree may live until 90, so may still desire/need some higher risk assets to finance a 25 year retirement), a low risk strategy is probably not suitable for younger investors.

Asset allocation is extremely important for investing success. It should not be based on emotion and fear of loss. Your asset allocation should be unique for you, based on your personal situation.

What to Do?

“After so much damage, clients are now in a risk-averse stance,” says Folda, “But the reality is that many households still need growth, they need exposure to at least some equity.”

“So volatility, while damaging for everybody,” says Folda, “can be opportunity for advisors to even further underscore the importance of good advice and solid solutions in establishing the right risk profiles for portfolios.”

I think there are a few keys to effectively deal with volatile markets.

Investors need to construct investor profiles and Investment Policy Statements. These will determine a proper target asset allocation and help maintain long-term focus during periods of short-term volatility.

A properly diversified portfolio will reduce portfolio risk without lowering expected returns.

Low cost investments such as open-ended index mutual and exchange traded funds will help with diversification and cost-effective investing.

While I understand that many advisors, banks, brokers, etc., want to sell investors innovative new products (that usually are quite profitable for the seller), be cautious. Minimizing your costs is a key to maximizing long-term success. Do not pay someone else 1-2% of your capital each year simply to purchase the flavour of the day.

Dollar cost averaging will also assist in dealing with volatility and staying disciplined.

If you use these techniques you will reduce emotion in your investment decisions. This will improve your portfolio construction and your probability of long-term investment success.




Diversify With Emerging Markets

Emerging market investments can add value to one’s portfolio.

On the one hand, emerging market assets provide potential diversification benefits that help lower overall portfolio risk.

At the same time, emerging markets offer potentially higher returns than investments in developed markets. This helps enhance overall portfolio expected returns.

Lower portfolio risk, higher expected returns, count me in!

Well, like any investment, there are always a few strings attached. 

The advantages of diversification into global markets today are less than they were 20 years ago. This is due to factors including: the ever increasing level of globalization, closer economic ties between countries, and improved information flows for investors.

Today we will take a look at the risk reducing benefits in adding emerging market assets to one’s portfolio. And the issues to watch out for.

Emerging Markets May Diversify Portfolio To Reduce Overall Risk 

As we saw in our look at diversification, asset correlations (i.e., connection between the assets) impact overall portfolio risk.

By adding assets with low or negative correlations to an existing portfolio, it reduces portfolio risk to some extent.

How Much Diversification Depends on Amount Added and the Inter-Asset Correlation

The exact amount depends on the amount of new asset being added. Obviously, if you add stock worth $1000 to a portfolio with a total value of $1 million, its impact will be smaller than if the entire portfolio was worth $2000.

The amount of risk reduction also is impacted by the inter-asset correlation. The lower the correlation between portfolio assets, the lower the overall portfolio risk.

Developed Markets May Have Close Economic Ties and High Correlations

Often emerging market assets have lower correlations with developed countries than do developed countries between themselves.

For example, Canada and the U.S. are closely related in many economic areas. If the U.S. economy suffers, there will be a significant impact on Canada. The same close relationship exists between European Union countries like France and Germany.

Developed nations tend to have similar markets, trading relationships, rule of law, consumers that enjoy similar products, etc. As such, systematic risk factors that impact one developed country can have an impact on all. The closer the relationship between two countries, the higher the inter-country correlation.

As the economic ties begin to fade, correlations between the countries fall.

Emerging Markets May Have Less Economic Ties to Developed Markets

With emerging market countries, often the connection between a specific country (e.g., Morocco) and your home country (e.g., Canada) is small. So you can get diversification benefits by adding emerging market assets to your investment portfolio.

The lack of connection between an emerging market and your home country may be due to a variety of factors. Proximity, lack of trade treaties, disposable income in the emergent market, resources, can all weaken ties (and correlations) between your country and the emerging market. For diversification purposes, this is good.

But Not Always

Even though one country is labelled an emerging market, its unique relationship with a second country determines its correlation.

Not simply whether one is developed and the other emergent.

This is a crucial point to remember.

You Must Always Compare The Specific Countries

Distance and economic development are often keys to correlations between countries.

The correlation between Mexico and the U.S. is higher than between the U.S. and Germany simply because of physical proximity and the resulting ties and trade. The same holds true between Germany and the Poland. But the relative correlations between Germany and Mexico or the U.S. and Poland will be smaller due to distance and lack of common borders.

Also, some large economies (e.g., Brazil, China, India, Russia) are included as emerging markets. Although considered emerging markets, these countries have close economic ties to many developed nations.

For example, China holds a huge amount of U.S. debt. And the U.S. is a big importer of Chinese made goods. Even though the two countries are physically far apart, their economic ties lead to a higher correlation than might otherwise expected.

So, in many instances, adding an emerging market investment to your portfolio will reduce your overall portfolio risk. But do not blindly assume that emerging market assets have lower correlations than other international assets. You need to dig a little deeper to see the specific relationship between the markets. Sometimes, the benefits will not be there.

The World Continues to Shrink

As the world continues to become smaller through increased globalization and information flow, diversification benefits have fallen.

Just look around you to see this is true. Not that many years ago, foreign automobiles in the U.S. were relatively rare. Today, Japanese, Korean, German, and others are the norm.

Consider Starbucks. Almost impossible to believe, but prior to 1996 there were no Starbucks outlets outside the U.S. It was only in 1998 that Starbucks opened a store in the United Kingdom. 13 years later, I cannot walk more than a block in downtown London without stumbling across a mermaid like sea siren. Today Starbucks operates in 57 countries with over 17,000 stores. And approximately 1000 of those are in the U.K.

Also, new free-trade agreements (FTAs) continue to develop that serve to enhance economic ties. In 2011, Canada completed a FTA with Colombia, concluded negotiations on a FTA with Honduras, tabled legislation on FTAs with Panama and Jordan, and continues to negotiate on a FTA with India. That Stephen Harper has been a busy fellow.

Complicating things further is that the German car driven by the Australian may have been built in the USA or South Africa. That Apple iPod bought by a Swiss person was made in China. And the American is getting his assistance from JPMorgan Chase or AT&T via a call centre employee in the Philippines.

As more and more companies shift resources to take advantage of lower cost jurisdictions, they increase their operations in emerging markets. This increases ties as well as correlations.

But There Are Exceptions

In general, the world is shrinking, which means a trend towards higher correlations between countries. But sometimes circumstances arise that reduce the current connections.

Greece is intimately connected to the European Union through the Euro. If it leaves the Euro, as may happen, the correlation between Greece and other Euro countries will fall. Probably not much given the physical proximity of European countries, but it will decrease to some degree.

Or look at the current situations in Egypt and Pakistan. The U.S. has had close military and economic assistance ties to each country. But as political circumstances change in both countries, there is a strong probability that ties between these nations and the U.S. will decrease.

Changing correlations is not necessarily a one-way street.

Conclusion

Including emerging market assets in one’s portfolio can provide diversification benefits by reducing overall portfolio risk.

But it is not the slam-dunk that it was 15 or 20 years ago.

You need to examine any emerging market in direct comparison to your home region. Australians will have closer economic ties to China, Indonesia, and the Philippines than a Brit.

And a specific emerging market may have a higher correlation to your existing portfolio than some developed markets. Japan has closer ties to China than it does to Sweden.

Finally, never forget that the world is fluid. As global events change, so too can correlations.

When considering adding emerging market assets in your existing portfolio, do your homework.

Make certain that the potential asset actually provides a diversification benefit by reducing overall portfolio risk.

And once it is in the portfolio, monitor world events to ensure that it continues to provide these benefits over time.

Next up, a look at how emerging market assets can enhance portfolio returns.





What are Emerging Markets?

Emerging markets are popular investments for many investors.

Why?

Emerging market investments may aid in reducing portfolio risk through enhanced diversification. At the same time, there is also the potential for higher returns in less developed markets.

Today we look at what constitutes an emerging market. 

Emerging markets are often seen as high flying investments in uncontrolled regulatory environments. Growth oriented assets with high price to earnings ratios. Located in far flung corners of the world, a long distance from your developed and well regulated domestic market.

But this is not necessarily true in all cases.

What is an Emerging Market?

Per Investopedia, an emerging market economy:

is defined as an economy with low to middle per capita income. Such countries constitute approximately 80% of the global population, and represent about 20% of the world’s economies.

… countries that fall into this category, varying from very big to very small, are usually considered emerging because of their developments and reforms.

… are characterized as transitional, meaning they are in the process of moving from a closed economy to an open market economy while building accountability within the system.

Because their markets are in transition and hence not stable, emerging markets offer an opportunity to investors who are looking to add some risk to their portfolios.

That is the financial world’s agreement on what constitutes an emerging market. Countries with lower per capita income and wealth. However, the size of the country’s economy can be big or small, which may surprise some investors.

The key aspect is that the country is in a financial transition. Moving from an unregulated, disorganized system towards one with better oversight, transparency, and rule of law. Things that give investors some confidence and therefore begin to attract domestic and foreign investment.

However, because the shift to full development is not complete and there is some probability of regression, investing in emerging markets is riskier than investing in a developed market. And with greater risk, there is the expectation of higher returns.

This, plus diversification benefits, is a major reason why investors take a chance on emerging markets.

Who are the Emerging Market Countries?

Anyone that meets the criteria above. You can make your own determination.

But in many financial instruments, an emerging market country is more closely defined. And some of the inclusions may not appear to many readers as emerging markets.

For example, the MSCI Emerging Markets Index currently includes only 21 countries in their index. As at May 30, 2011, the index only included:

Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Brazil, China, India, and Russia have substantial economies, yet they are still considered emerging markets. That said, these countries are also often segregated into their own fund, known as BRICs.

Frontier Markets

And where are countries such as Kenya, Lebanon, and the Ukraine? Are they not also emerging markets?

Yes. But they tend not to be included in emerging market indices or funds. Instead they are classified as “frontier markets”, reflecting even less development.

As at May 30, 2011, the MSCI Frontier Markets Index includes 25 countries, with a few more under consideration.

Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kenya, Kuwait, Lebanon, Lithuania, Kazakhstan, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, and Vietnam. The MSCI Saudi Arabia Index is currently not included in the MSCI Frontier Markets Index but is part of the MSCI Gulf Cooperation Council (GCC) Countries Index. The MSCI Bosnia Herzegovina Index, the MSCI Botswana Index, the MSCI Ghana Index, the MSCI Jamaica Index, MSCI Trinidad  & Tobago and the MSCI Zimbabwe Index are currently stand-alone country indices and are not included in the MSCI Frontier Markets Index. The addition of these country indices to the MSCI Frontier Markets Index is under consideration.

Know What You Are Investing In

A wide range of countries are considered emerging markets.

In some cases, the term “emerging market” may not seem appropriate for some of these countries. India, Brazil, China, and Russia may come to mind. All have large economies and close ties to many developed nations.

And in some cases, countries that are really emerging markets are not classified as such. Argentina, Croatia, Estonia, Lithuania, the Ukraine, and Vietnam are emerging markets, but categorized as frontier markets. And countries such as Ghana, Jamaica, and Saudi Arabia are neither currently classified as emerging or frontier markets.

When assessing potential investments, do not assume that an emerging market investment falls under a common sense perspective. You need to dig a little deeper to really know what you are investing in.

That way, you will be able to build a more effective and efficient investment portfolio.

Next a look at the potential advantages of adding emerging market assets to your portfolio.





Are You Saving Too Much?

I read an article entitled, “Are You Saving Too Much for Retirement?”

I think it is a good article to discuss. No, the article itself is not good. Far from it. Rather this type of article is good to discuss. A big difference. 

First, let me say that I do not like to criticize other writers. Everyone has their own perspective and that is fine with me.

But too often I come across information that is just plain bad. And if read by someone with limited investment knowledge, can lead to potentially terrible results.

Today is one of those days.

It turned into a long post, sorry. But it drives me crazy seeing terrible financial advice out there.

Let us go through some key points from the article.

One Size Fits All

Retirement planning almost always starts with one number: A guesstimate of the percentage of pre-retirement income you’re expected to need after you retire. That’s called the “replacement rate” and is often pegged by industry experts at around 80 percent of a household’s earnings.

Perhaps I am not an “industry expert” (although my professional designations and experience would say I am) but good advisors would not arbitrarily assume an 80% figure.

If they did, that indicates that a household earning $2 million per year requires $1.6 million in retirement. And a household earning $40,000 requires only $32,000 annually in retirement.

Should you live in retirement as your earned in your work life? Maybe.

I would say maybe not. Your retirement income should be a function of your lifetime savings, not a guesstimate based on pre-retirement earnings.

You Need Solutions That Fit You

Competent advisors conduct a needs test to help determine your potential requirements. It incorporates a variety of factors and should be based on your unique circumstances.

One one side you have existing costs. At retirement, you likely will no longer have a home mortgage, car loan, education costs for your children, etc. You will not have employment related costs, such as transportation each day, dry cleaning, tools, eating out, etc. In many areas your costs will sharply fall.

What percentage depends on your personal circumstances. The choices you made in life. And what you chose will likely be different from your neighbour.

Countering this are the potential new costs in retirement. If your family history is of long life, you may want to plan for a longer retirement period than the average person. Or if you have been diagnosed with a medical condition, you may need additional funds to deal with it. If you want to travel the world or live in a tropical paradise, that needs to be considered. If you want to engage in philanthropic activities, that needs to be calculated.

The list of retirement needs and desires is endless. And in a package they are unique for each individual.

One size does not fit all. It is a mistake to think so.

It is even a bigger mistake to rely on an advisor that uses this system to plan.

We May Be Saving Too Much

In the article, Ms. Bonnie-Jeanne MacDonald thinks people may be saving too much and that they do not need to make that level of sacrifice for a comfortable retirement.

That has big implications for workers who are now exhorted on a daily basis to save more and more, ‘lest they run out of money in retirement. If you really don’t need 70 percent or 80 percent of your last paycheck for the rest of your life, you don’t have to save enough to produce that figure. And saving too much has its consequences, says MacDonald.

“It’s not coming from nowhere; it means you’re making big reductions in your standard of living before retirement to make your standard of living higher after retirement,” she explains.

A fair bit of nonsense.

First is the assumption that one does not necessarily need 70-80% of one’s last paycheck to have a pleasant retirement. This may be true or not. As we saw above, it depends entirely on the individual in question.

Second is that saving more will result in significant reductions in one’s current standard of living. How does she know? Accumulated wealth is a function of multiple variables. How you use them dictates the level of sacrifice.

Third is that saving more will result in a higher standard of living in retirement. Maybe, but maybe not as we shall see below.

We will look at the second and third points below.

Saving Money Requires Significant Sacrifice

Wealth accumulation is based on many factors.

Some factors may cause saving to involve significant sacrifice. But proper planning can make the process manageable. Also, I would rather sacrifice a little during my earning years than to reach 65, with no employment and not enough enough wealth to live above the poverty line.

But perhaps that is just me.

We covered a lot of wealth accumulation factors in our review of compound returns.

Time

Time is a huge component of accumulating wealth. If you start at age 25, you can contribute much less, both periodically and cumulatively, than if you wait until 35 or 40 to start saving.

Perhaps I want to save $1 million at age 65. I am starting with zero saved and have annual after-tax income of $50,000. Further, I am guaranteed a return of 6% per annum. If I wait until I am 45 to begin saving, sure it will be painful. I will need to save about $2200 per month and contribute $528,000 over the 20 year period.

But if I start saving a little younger, the pain eases. Starting at 35, I only need to save about $1000 per month and contribute $380,000 in total over 30 years. And if I begin at 25, my monthly contribution falls to $500 and my total drops to $240,000.

Maybe I have to budget a little better when young, but $500 per month is preferable to $2200. Not to mention that as I age, I will have more disposable income that I can allot on top of my monthly requirement. This will grow my nest egg even more.

Start investing as soon as you can. Even if it is a limited amount, it will grow nicely over the long run.

Rate of Return

Rate of return is also key to wealth accumulation.

Many planners use historic rates of return to extrapolate future returns. For U.S. large cap stocks, that equates to 7.4% net of inflation return. For bonds, 2.4%. For Treasury-bills, 0.7%.

Smart advisors often incorporate a bit of conservatism in their calculations for safety.

For example, T. Rowe Price currently uses the following assumptions in their expected rate of return calculations “all presented in excess of inflation: for stocks, 4.90%, for bonds, 2.23% and for short-term bonds, 1.38%.”

I might be a little more cautious than T. Rowe Price. I would rather err on the low side and end up with excess wealth than to be too optimistic and have to live on Kraft dinner and popcorn.

In our example above, I used a 6% rate of return. At 25, I need to contribute $500 monthly to reach $1 million by age 65. If I only achieve 5% annually, my end wealth would only reach $763,000 at age 65. At that return I need to increase my monthly contributions to $660 to reach $1 million.

On the plus side though, if I can eke out an extra percent to 7% annually, my $500 per month will grow to $1.3 million by age 65. Not a bad incremental return just by earning an additional 1% return.

As an aside, this shows the importance of prudently taking on additional risk (with higher expected returns) if you are a younger investor.

Saving Now Will Result in a Higher Standard of Living Later

And this is a bad thing? It seems so according to Ms. MacDonald.

I would not mind living a better life than I do now. I think many people share my opinion.

But will saving now necessarily lead to a higher standard of living in retirement than we enjoy now?

Possibly not. Why?

Prices Never Stay the Same

Inflation erodes your purchasing power.

You spend $10,000 on a vacation today. If inflation is 3% (the U.S. historic average) over the next year, that same trip will cost $10,300. Okay, maybe not that bad.

But how about if you are 40 and want to take that dream vacation at age 65. Inflation of 3% over 25 years will make that same vacation cost around $21,000. Or if you are only 25, that vacation will balloon from $10,000 today to $32,600 in 40 years.

A bit of difference in your planning requirements.

And who is to say that inflation will maintain its historic average of 3%. Globally, governments are running substantial deficits leading to historically high debt levels. Money is being printed to help deal with economic crises. All these can create higher inflation.

And what if you are low on your inflation estimates? Say you factor 3% when it turns out to be 5% on average. That $10,000 vacation now becomes $34,000 in 25 years and $70,000 in 40 years.

Think that 5% is not possible? Talk to someone who experienced the late 1970s or early 1980s. In 1980, the U.S. inflation rate reached 13.6%.

And for those that believe inflation will also be reflected in higher salaries and investment returns, not correct.

For wage earners who have Cost of Living Allowance (COLA) clauses that provide annual wage increases to account for inflation, there are difficulties. Namely in that often the official inflation figures omit key items that impact consumers.

For investors of fixed income assets, only those on the extremely short end can somewhat keep pace with inflation. But if you buy a 10 or 30 year bond that yields 5% and inflation increases to 6% during that period you will have negative real returns.

Again, err on the conservative side when factoring inflation into your retirement needs analysis.

Taxes Will Rise

What you pay today in taxes will not be the same as when you retire (assuming more than 5 years out).

National, regional, and local taxes will rise. Both direct and indirect (e.g. taxes on gasoline). They have to in order to finance the huge government debt loads, social welfare services, and pensions for government employees.

User fees will also rise and new fees will be introduced. I call these taxes, but government calls them fees, so I will play the game. These fees will be imposed in areas where they will raise revenue. As an increasing number of people are retiring, look for new and/or higher fees in respect of leisure activities.

When calculating your net retirement income, factor in higher tax rates than are experienced today.

Pensions Will Fall

Many people expect government pensions to offset their other retirement income.

This is a mistake.

Over time, governments will cut back on social welfare pensions simply because they cannot afford them. This may be in the form of clawbacks (i.e. means testing), higher age requirements, reduced payouts, etc.

As well, there is the potential for individuals who are entitled to defined benefit pensions to suffer from reduced payouts. Many corporations and governments are significantly underfunded in financing employee pension schemes. If you are in such a situation, there is a possibility that you will not receive what you are owed.

When calculating retirement needs, do not blindly include government old age pensions. And have a little skepticism if you are a member of an underfunded defined benefit pension plan. If you count on these income streams to finance your retirement fund shortfall, you might be in trouble.

Despite your savings pattern, there are no guarantees that you will enjoy a better lifestyle in retirement than you do pre-retirement.

A Lot of Doom and Gloom

Okay, that was a lot of doom and gloom.

But it is important to always take a conservative approach when planning for retirement. This notion that we are saving too much and need not sacrifice anything for retirement is insane. Possibly economically suicidal.

With luck, we will see the return of strong bull markets with little inflation. These will lead to higher personal and corporate incomes that will pay down government debt and allow for lower tax rates and continued social welfare payouts.

I have my doubts, but let us say it we do get lucky. What is the worst for you? You scrimped a little during your work years and ended up with a pile of excess retirement capital. Not bad.

We can take all our extra wealth and build a monument to Ms. MacDonald in tribute to her vastly superior intellect.

But if we do not get lucky, where are you? If you follow the wisdom of Ms. MacDonald, you are in big trouble. May I suggest at that point you give Ms. MacDonald a call for financial assistance. I am certain she will give you a hand. Or not.

However, if you do save as much as is possible under a proper investment plan, you may still be okay. At least better off than many of your peers who did not properly plan.

Hope for the best, but plan for the worst.

If you do, you will be miles ahead of most people.





Assessing Investment Returns

In our first look at investment returns, we reviewed a few common return calculations.

If you know the formulas, the calculations are quite simple. The key is to know what is included and excluded from the different returns.

But even with the hard calculations, returns can mean different things to different investors.

Today we will consider some of the qualitative aspects in evaluating investment returns.

Return, like risk, is in the eye of the beholder. Never be seduced simply by the quantitative side of investment returns. Always look at results from a other angles as well.

I think this is just as important as the hard numbers.

Unfortunately, it is an area many investors ignore to varying degrees.

Do so at your own peril.

Expected Rate of Return

Before we get into today’s session, I quickly want to review a topic we have previously discussed.

Expected return is the anticipated asset performance for the future period under consideration.

There are a variety of ways to calculate expected returns and most incorporate multiple variables.

Historic returns, probability and scenario analysis, company specific expectations, general market and industry specific expectations, risks, risk-free returns, etc. There are many factors that go into determining an asset’s expected return.

Because these returns are expected, there is a probability that the actual results will differ.

This is where our earlier discussions of standard deviations come into play. The larger the standard deviation (i.e. the greater the volatility of the asset), the less likely that the actual return will equal the expected return.

As the level of risk lessens, the certainty of the result rises. It is only in investments that have no risk that the expected return will always match the nominal return.

In our analysis below, we shall use this simple example.

You invest $1000 in an asset on January 1. You sell the asset December 31 for $1250. There were no cash flows so your total return (also, in this example, your holding period and annual returns) is $250 or 25%.

Nominal Rate of Return

While expected returns are forward looking, nominal returns reflect what actually occurred.

This is the most common way to express a return.

The nominal return is the investment return unadjusted for any other factors. In our example, the nominal return is 25%.

A good number to know. But on its own, there is no context.

And we always need context. Well, at least those who want to properly invest do.

How do we put nominal returns in context? You need to use comparative data.

Real Rate of Return

The real rate of return adjusts the nominal return to eliminate any impact from inflation.

We discussed the affect of inflation previously.

Let’s say that your investment above was made in the United States where the annual inflation rate is running at 3%. Your real rate of return therefore is only 22% (25% nominal minus 3% inflation).

Not too significant an impact.

However, perhaps you live in Venezuela where inflation is about 30% annually. Your real return becomes a loss of -5%. Even though you made a 25% profit (on which you will be taxed), you have actually lost 5% in purchasing power over the year.

When investing, always consider the impact of inflation on your returns. Its impact on your real returns can be substantial.

Risk-free Rate of Return

The risk-free rate of return is the return on an investment that carries no risk.

That is, the outcome or return is known with 100% certainty. If the expected return is 10% or $100, you are fully guaranteed the result.

While it is debatable as to whether any investment can be termed risk-free, for investment purposes certain government short term debt issues are considered to be certain. In the United States, the 13 week US Treasury Bill (T-bill) is considered to be a risk-free investment at this time.

Why is knowing the risk-free rate of return important?

It is believed that investors are rational creatures. That means that all else equal, investors will choose the more efficient investment option when faced with two choices.

Efficiency, in this case, refers to the relationship between risk and return. When having a choice between two investments of identical risk, investors will always select the asset with the higher expected return. Alternatively, when choosing between two investments with identical expected returns, investors will choose the asset with the lesser risk.

While not always followed in practice, it should make sense.

For example, say 13 week US T-bills offer a effective, annual return of 10%. In essence, the risk-free rate is also 10%. That means you could invest in T-bills and be guaranteed a nominal annual return of exactly 10%.

Since all other investments have a higher level of risk, rational investors will never accept less than a 10% expected return for a risky investment.

The greater the risk, the higher the return demanded by the investor.

US government bonds are less risky than most corporate bonds. Therefore, if you look up yields on different bonds, you will see higher yields on corporate versus US government bonds with the same characteristics.

Similarly, riskier companies must pay higher interest rates than more secure companies.

This is the same as personal loans from your bank. If you are a valued client with lots of assets, you might get a loan at the prime interest rate. But if you have no track record of repayment or have had difficulties making debt payments in the past, you will need to pay higher rates than prime.

Use the risk-free rate of return as a minimum benchmark when considering investment options.

If the risk-free rate is 10% and you are contemplating an investment with an expected return of 15% and standard deviation of 10%, you might give pause. Yes, the potential return is higher than US T-bills, but the risk is significantly higher. In fact, 95% of the time, your actual return will be anywhere between 35% (good) and -5% (not so good).

Whether you think this is a better investment than the T-bills is based on your own risk tolerance.

But by knowing the risk-free rate, you have additional information to make better decisions.

Relative Rate of Return

With the real and risk-free rates of return we considered investment options relative to inflation rates and guaranteed returns respectively.

But you should also compare your investment returns to other benchmarks. These include: prior year results; analyst or company expectations; the market as a whole; the industry in which the asset lies; predetermined benchmarks.

In our example, the nominal return was 25%. Sound’s good.

Actually, I have no idea if it is good or bad. I need more information.

Perhaps the investment in our example was Fantasy Bank shares.

I would be interested in how the shares performed over the previous years. If the 5 year average return was 40%, maybe 25% this year is relatively weak.

What if I told you the general stock market grew 12% over the year and that the average banking industry shares rose 30%. You would be happy that your stock outperformed the general market return, but unhappy that you underperformed other banking stocks.

When examining potential investments, you consider the expected returns. For many investments, analysts and industry experts have expectations for the coming year’s returns. If analysts had predicted that Fantasy would grow by 50%, you might be disappointed with 25%. Especially if you based your investment on a risk-return profile incorporating the 50% expected return.

You can set up a variety of other benchmarks to compare performance. But you should always compare your actual and expected returns relative to predetermined criteria.

That gives you a few thoughts as to why you should never consider investment returns in isolation.

Always compare your actual and expected returns agains relevant benchmarks.

Your decision-making and portfolio performance will benefit.

Next in our investment series, some further evidence that all returns are not the same.




A Little More on Diversification

Today we shall look at a few more areas of interest relating to diversification.

In An Introduction to Diversification, we saw that Investopedia recommends holding a “wide variety of investments” to benefit from diversification.

Further, that a diversified portfolio will generate “higher returns and pose a lower risk than any individual investment found within the portfolio”?

Is this true? What does it mean?

A Wide Variety of Investments?

The greater the number of investments in one’s portfolio, the greater the diversification.

This implies that you should have as many investments as possible in your portfolio.

However, the greater the number, the less the impact from any one additional investment.

If you have a single asset portfolio and add a second asset to the mix, there will be significant impact from the new asset. But if you have 1000 assets equally in your portfolio, the addition of one more will have minimal influence.

So what is the ideal number?

The optimal number of individual investments, excluding such things as funds, fluctuates slightly from study to study. Some claim that 20-30 proper investments will result in strong diversification.  Other studies found that 15-20 stocks can provide adequate diversification to eliminate nonsystematic risk. Some studies even believe that the benefits of diversification are exhausted in portfolios with more than 15 investments.

As to what is the right number, I think it varies depending on the investor. I could build a portfolio of 10 or less assets that managed to diversify efficiently. Others might need 40 to properly diversify.

The key to effective diversification is the correlation between the investments.

If you are comfortable investing in fine art as part of your investment portfolio, you do not require many assets to diversify. If you only want to invest in North American based public companies, you will require significantly more assets to diversify.

Regardless of the “right” number, you can see that it is not substantial. And by that, I mean less than 50 individual assets.

Less investments are also better for long term compounding. Buying and selling multiple investments results in transaction costs and potentially taxes payable on any gains. As we discussed during our compound returns review, these two costs can significantly erode long term portfolio growth.

Another factor to bear in mind is that researching and monitoring 30-50 investments can require substantial time and energy.

Higher Returns Through Diversification?

I have thought a bit more about the Investopedia statement. It is still inaccurate, but I think I can explain it.

I do not believe that you can get higher returns just by diversifying. As I explained previously, a portfolio’s expected return is simply the weighted average of every component’s expected return.

But diversification does allow the ability to add higher return assets to the portfolio to improve the overall expected return of the portfolio.

Say you have a two asset portfolio. Asset A has an expected return of 10.0% and a standard deviation of 5.0%. Investment B has a 14.0% expected return and a standard deviation of 8.0%. Your portfolio is 50% of each and the correlation between the two assets is 0.70.

Skipping the calculations, click here if you want to see the basic formulas, the portfolio has an expected return of 12.0% and a standard deviation of 6.0%. Note that we have already breached the Investopedia statement that a diversified portfolio will yield higher returns than any individual investments in the portfolio.

But we can get a nice increase in expected returns by adding a high risk investment to the mix. Let us add asset C with an expected return of 50.0%, but a standard deviation of 30.0%. Further the correlation between asset A is 0.60 and 0.90 with asset B.

The ABC portfolio will have an expected return of 24.6%, a huge increase from the 12.0% expected return of an AB portfolio. But again, the higher average is less than the return of asset C on its own.

So while you may be able to increase expected performance in a portfolio, it will never be greater than the return of all individual assets.

What about risk though?

Lower Risk Through Diversification?

As we saw with our correlation calculations, proper diversification will lower portfolio risk. Again, not necessarily lower than all individual assets though.

In our two asset AB portfolio, the standard deviation is 6.0%. Less than asset B’s risk of 8.0% but more than asset A’s 5.0%.

Now let us look at adding asset C to the risk calculation.

The standard deviation of ABC portfolio is 13.5%. Now the combined risk is higher than both A and B on their own and even the AB portfolio itself.

Like returns, Investopedia’s statement on lower risk is faulty.

What Should Investopedia Have Stated?

I might have looked at the impact of diversification on portfolio returns and risk.

For a given return level, proper diversification will reduce the portfolio risk.

Or for a given risk level, proper diversification will provide higher returns.

But that is for the portfolio as a whole, not compared to its individual investments.

For example, you have a single asset portfolio, asset X. Its expected return is 20.0% and its standard deviation is 10.0%.

You like the return but are concerned about the amount of risk. You decide to add another asset in a 50% mix of the two assets.

You find two other potential investments that both have 20.0% expected returns.

Investment Y has a standard deviation of 10.0%, the same as your current asset X. Asset Y has a 0.20 correlation to asset X.

Investment Z has a standard deviation of 7.0%, lower than asset X. Its correlation to asset X is 0.90.

An XY portfolio will have an expected return of 20.0%. But an XY standard deviation will only be 7.8%.

An XZ portfolio will also have an expected return of 20.0%. But the XZ standard deviation will be 8.3%.

Both portfolios are more efficient than holding asset X alone.

For further points, note that the XY is more efficient than XZ even though Y has a higher amount of risk than Z. That is because of the differences in correlations.

The same may be said for someone wanting to enhance portfolio returns while keeping risk stable.

You own asset X and are comfortable with portfolio risk of 10.0%. However, you would like to increase your potential returns.

Perhaps you find investment option S with an expected return of 28.0%, a standard deviation of 13.0% and a correlation with X of 0.50.

In combining the two assets equally, the expected return of XS has increased to 24.0%, but the standard deviation remains the same at 10.0%.

Again, correlation plays a significant role in risk reduction. Had the correlations been 0.90 rather than 0.50, the standard deviation of XY would be 11.2%. For investment options with high correlations, you would need to accept lower risk-return profiles to equal the risk of X alone.

Okay, I hope that helps clarify diversification.

If not, do not worry. It is a rather complicated subject. I just want to lay the groundwork now for when we look at asset allocation and portfolio construction strategies.

I think we will move on to a discussion of investment returns next.




Limitations of Standard Deviations

While standard deviations are indeed useful, be aware that there are limitations to their use.

Here are a few things you should consider before using standard deviations as a risk measure.

Asymmetric Payoffs

In our previous discussion, we used examples with normal distributions. There was a reason for that. Standard deviations are poor tools for investments with asymmetric payoff profiles.

In a normal distribution, the payoff profile is symmetric. The normal distribution curve should look the same on both sides of the mean. Results should be equally disbursed around the middle. The tails on each end of the curve are symmetric. That is why one can use multiples of the standard deviation (e.g. 2 standard deviations from the mean contains 95% of all potential results) to determine outcome probabilities.

In an asymmetric profile, the distribution curve is skewed on one side of the mean or the other. By skewed, I mean that the tails are unequal in the distribution outcomes.

If the left side tail is more pronounced, then there are more actual results to the right side of the mean. But there are a relatively few extremely small valued outliers that drag the tail of the curve leftward. That is known as being negatively skewed.

If the right side of the curve is longer, then there are more results on the left side of the mean. But there are a relatively small number of extremely high value outliers that push the tail to the right. In this case, the distribution would be positively skewed.

It should be easy to see why skewed distributions limit the usefulness of the standard deviation as a risk measurement. In the graphs above, say the mean is 10 and the standard deviation is 2. 68% of the results should lie within 8 and 12. 95% of all outcomes should lie between 6 and 14. But, as you can see, the distribution pattern is not symmetric. So it is unlikely that the results will fall in the range as intended for standard deviation to be helpful in analyzing the investment.

In the real world, positively skewed distributions are more common than negative ones.

Compensation in a company is a good example. Say you have 100 people in a company and the average, or mean, salary is $50,000. Of the 100 staff, most likely earn close to that $50,000. Some will make less than the average. But even the most junior staff will earn a minimum level, perhaps $10,000 to $20,000. That would be the tail on the left end of the curve.

If compensation in companies was normally distributed then one would expect that senior management would receive approximately $80,000 to $90,000. In reality though, the President and direct subordinates may earn substantially more. In this example we will say that the President earns $325,000 and the three Vice-Presidents earn $225,000 each.

Senior management is very few in number, but they distort the distribution curve in two ways.

One, if total compensation for the company is $5 million (100 staff averaging $50,000 each), yet only 4% of all employees earn 20% of the compensation (4 senior staff make $1 million combined), that inflates the overall mean to some degree for the typical employee.

If you eliminated those 4 from the calculation, there would be 96 staff earning $4 million. That would result in a mean of only $41,667 for non-senior management employees. A significant difference is someone wants a raise.

Two, the very small number of extremely high value earnings will lie on the very far right side of the distribution. These salaries will push the curve much farther to the right than if all compensation was normally distributed. This results in the long right-hand tail and the positive skewing of the distribution.

You can likely think of many more examples of where outcomes are not symmetric in reality.

In the realm of investing, options strategies and portfolio insurance are two examples of investments with asymmetric payoff profiles.

Not areas we shall delve too deeply into. However, I wanted to properly explain asymmetric distributions to further reinforce the understanding of normal distributions.

The Past is Not the Future

A second issue with standard deviations is their use of historic data. Past results might be a predictor of the future, but results may also change over time.

New management, different product lines, increased competition, expiration of patents, etc., all may impact future results and therefore alter the standard deviation.

Be careful in placing too much faith in historic results.

Standard Deviations Need a Context

Standard deviations should never be considered on their own. One needs to factor in the expected return as well.

For example, investment A has a standard deviation of 6%. Investment B has a standard deviation of 10%. If you only look at the standard deviation, B is the riskier investment.

But what if I also tell you that the expected return for A is 4% and 15% for B?

At a 95% confidence interval below the expected return, you could actually lose more with investment A than B. Without getting into the calculations, you could lose 5.9% with A and only lose 1.5% with B.

To address this issue, you need to consider the concept of “Value at Risk”. We may or may not get into this slightly more complex topic at a later date. But no promises or threats.

Human Behaviour

Standard deviations are unable to quantify behavioural aspects of investing risk.

We will devote some time to Behavioural Risk issues at a later date. In essence, it looks at how human behaviour affects the investing decision-making process .

It is an interesting and important topic. And it will not put you to sleep.

So there is a quick overview on the limitations of standard deviations as a risk measure.

I hope our look at standard deviations and means brought some clarity and not further confusion. If the latter, do not get too frustrated. For most people statistics is not the easiest of subjects. And we only took a quick look at the subject.

As an investor, I do not expect that you will need to calculate many means or distributions. But it is important to understand what they are and why they are useful in investing.

Next up, a look at the two main components of investment risk.




Investment Risk in Greater Detail

Today we look at investment risk in greater detail.

This expands on our preliminary discussion in Defining Investment Risk.

Investment Risk Revisited

Previously we defined investment risk as a speculative risk. As such, investment risks provide the possibility of incurring a loss, breaking even, or profiting.

I stated that investment risk is the probability that the actual returns on an investment will differ from the expected returns. The higher the probability of a different result, the greater the risk. The lower the probability of a different result (or the greater the certainty of the same result), the lower the risk.

For those of you poor souls who have taken statistics courses, investment risk is typically viewed from a normal distribution perspective. The graph below is an example of a normal distribution curve.

Normal Distribution Curve

Normal Distribution Curve

Not the easiest concept to explain in a blog post (augmented by the fact that I am not a statistics professor), so we shall try and keep this basic.

Like head-ache medication though, I caution you not to read this post while driving or operating heavy equipment. The following may just put you to sleep.

Normal Distribution

You may also recognize the graph above as a Bell curve, so named for its shape. Or you may have heard it called a Gaussian distribution; named after Carl Friedrich Gauss.

Within a normal distribution, historic outcomes are placed on the graph and a distribution similar to the one above typically results.

It is called normal because the potential outcomes are symmetric in nature. You can see this by the equal spread of outcomes on both sides of the curve. Notice how the tails on both the left and right sides of the curve are similar in distribution.

If the distribution was not normal, but rather skewed, one end of the curve would be longer and more pronounced than the other end.

The important thing to note with a normal distribution is the way the Bell curve looks. As you can see, most of the actual results cluster relatively close to the middle of graph. The higher the curve, the more results are at that level. As you move farther from the middle, the number of results decreases. This creates the diminishing tails at either end.

Mean

In investing, the mean is the expected return on the investment. This is represented by the average result on the above normal distribution curve, located at position 0.

The expected return may be calculated based on historical data, theoretical probability models, experience, and professional judgement.

Because most investments have some risk, actual results may differ from the expected outcome. Actual results will usually lie somewhere to the left or right of the expected return. That said, there is no reason that they cannot fall exactly on the mean.

Investment Risk

So we know that the expected return of an investment is the mean, or average, in a normal distribution. We also know that the actual results will fall on either side of the mean.

But what does that tell us about the investment risk?

The investment risk is the variability of the actual returns around the mean.

As you can see above, actual results may be both greater or less than the expected return. So investment risk applies to the possibility of higher than expected returns, not simply lower than expected ones. However, investors are usually more concerned with results to the left of the curve. That is, where the actual performance is less than the expected returns.

The risk of an investment is determined by the variability, also known as volatility, of the actual returns around the expected return. Volatility is the amount of fluctuation in the actual returns from the expected returns. The greater the degree of volatility, the greater the risk of the investment.

The tighter the probability distribution of the expected future returns around the mean, the greater the certainty of the returns. As the certainty of the return increases (i.e. the less potential difference between the actual and expected result), the smaller the amount of uncertainty or risk.  In a normal distribution curve, the vast majority of actual results would amass extremely close to the mean. The bell would be quite high and narrow in width.

For results with high variability, the actual returns would be disbursed much farther from the mean. This would cause the bell shape to be shorter in height and much wider in width.

For example, investment “A” has an expected return of 5% and the actual returns over the last 6 years were 4%, 6%, 5%, 5%, 6%, 4%. The distribution around the 5% mean is quite tight. You would be right to expect the return over the next year to be close to the expected outcome.

Investment “B” also has an expected return of 5%. However, its performance for the last 6 years was 2%, 12%, -4%, 15%, -3%, 8%. The actual results are significantly different from the expected result. You may be concerned that the actual result for the upcoming year will not be close to the expected return of 5%.

Here you have two investments with the same expected return. Yet the certainty of earning 5% on A is pretty high for next year while there is very little guarantee as to what B returns. It may be 5%. Or it may be significantly different than 5%. Even experiencing a loss.

That is investment risk.

So how does one differentiate between the two investments?

Standard Deviation

In comparing two investments with the same expected return, it is extremely useful to quantify the investment risk.

To be of any practical use, a measure of risk must have a definitive value that may be analyzed by investors. The standard deviation is the statistical measurement of the movement of returns around the mean.

In investing terms, the standard deviation is the measure of the total risk of the investment.

Under a normal distribution, the majority of actual returns will occur relatively close to the mean or expected return. This is good for predicting future results.

In any normal distribution, 68% of all returns will fall within 1 standard deviation of the mean. 95% of all returns will take place within 2 standard deviations of the mean. And 98% of all returns will occur within 3 standard deviations of the mean.

This is consistent in any normal distribution scenario.

So if you are concerned about negative returns, under a normal distribution, there is only a 2.5% probability that the next year’s actual return will be lower than 2 standard deviations from the mean. That is good to know.

Note that there is a 95% probability that a return will fall within 2 standard deviations of the mean. So there is a 2.5% probability that next year’s return will exceed 2 standard deviations (i.e. the far right tail of the curve) and a 2.5% chance that the return will be below 2 standard deviations from the mean.

Theory, theory, theory. Let us look at how this applies to real world investing.

An Example of Standard Deviation

Perhaps you have two investment choices. Choice A offers an expected return of 10% over a one year period. Option B offers an expected return of 13% over the same period.

Ceteris paribus (all else equal), investment B should be your choice as it offers a 30% higher expected return for the year.

But all else is never equal, except in Latin phrases.

You notice during your research that each investment has a standard deviation assigned to it. Investment A has a standard deviation of 2. Investment B has a standard deviation of 9. You also note that both investments have normal distributions.

So how can standard deviations help your investment decision?

Remember that 68% of the time, actual returns will lie within 1 standard deviation of the expected return and within 2 standard deviations 95% of the time.

Investment A has an expected return of 10% and a standard deviation of 2. That means that 68% of all possible returns you may actually achieve are between 8% and 12%. It also means that 95% of the time you will experience returns between 6% and 14%.

For investors worried about experiencing a loss or lower than desired returns, 95% of the time they will, at worst, earn a 6% return.

Investment B has an expected return of 13% but a standard deviation of 9. So 68% of the results will lie between 4% and 22%. And 95% of the returns will be between -5% and 31%.

Very nice upside potential. But if you are concerned about lower potential returns or even losses, investment B might be too risky.

Armed with this new standard deviation information, does your investment decision change?

It might, it might not.

Investment Risk is a Relative Concept

As we discussed previously, the concept of risk is different for every individual.

Risk is therefore a relative term, not an absolute.

Some investors want to limit their downside investment risk and any possibility of experiencing a loss. Widows and orphans are in this group. As are many other investors.

These individuals willingly accept a lower expected return in exchange for a greater certainty of that return being realized. Investments whose potential returns are less volatile or variable are desired. A less risky result is preferable to higher potential returns (and more risk).

Other investors might be lured by the potentially high returns of investment B. Option A should rise no higher than 14% (97.5% of the time), whereas investment B could beat that return easily (of course, it could also do significantly worse as well).

Risk Aversion Versus Risk Seeking

While each investor takes a different view of risk, most investors (as opposed to speculators, whom we will discuss later) tend to be risk averse. That is, when faced with two investment choices of similar return, select the less risky one.

In contrast, risk seekers will actively assume greater levels of risk in the hopes of achieving higher returns. Their risk tolerance is significantly higher than risk avoiders.

In the capital markets, you need some investors to be risk seekers and others to be risk avoiders. The system will not properly function if everyone is the same. As we will see later, hedgers actively attempt to reduce their risk exposure. But they need to transfer that risk somewhere. Without risk seekers, there would be no one to assume the hedger’s risk and the markets would be very inefficient.

In looking back at the example above, I would suggest that investment A is the better choice based solely on the information given. I say that because the relatively greater expected return of investment B is not great enough to warrant the significantly higher level of risk you must assume. So while I have no problem with risk seekers as an investor class, risk should be assumed prudently.

In the near future we will look at the risk-return relationship and the implications of risk aversion and risk seeking on investment decisions. After which, please revisit this example and see if your original opinion has changed at all.

Regardless of your personal risk profile, the standard deviation of an investment is a very useful piece of information to have at hand. But be aware that there are limitations to the use of standard deviations.

We will look at these limitations in my next post.