| Introducing the Risk Manager |
That says it all, indicating simply that past performance is not a guarantee for future performance. Even though past performance gives you some confidence on how the company or the investment fund is managed and what you can expect in the future, it all stays within a certain level of expectation.
Imagine you look at your portfolio, and you want to know how much you expect to have in 5 years time to be able to buy a property. The property is your goal, and you want it absolutely! It is what keeps you awake when dreaming about the future. You then decide on a portfolio which is expected to yield 8% return per annum, and a quick calculation gives you how much your portfolio should be valued at in 5 years time. If your financial plan is well constructed, the calculation will tell you that the said portfolio will allow you to realize that dream property in 5 years time.
However, here is the problem: the average past performance of your portfolio is 8% per annum, but it does not mean the performance was flat over all these years. Additionally, at 8% per annum, you can be sure that the future performance won’t be flat either, there will be years of strong performance and years of bad performance, and maybe even losses.
Risk in function of the distributionSo how do we take this into account? First of all, it is important to understand how returns behave. Annual returns are built up over time, where each daily return is part of the annual return. Daily returns are different every day, one day it is positive, one day it is negative, and the average daily return is positive. For example, the average daily return might be 0.032%, which will give approximately 8% per annum. However, this is the average return, with a distribution around the mean. The distribution is expected to be a normal distribution as depicted in Figure 1.
Figure 1
In statistics, each distribution has a mean (or average) and a standard deviation. We already know what the average is, so let’s have a look at the meaning of standard deviation. The standard deviation measures the width of the distribution, or in other words, by how much we can expect the daily average to deviate from its mean.
For a normal distribution as depicted in Figure 1, the standard deviation will tell you that 68% of the time, we can expect the daily return to be with a range of the mean plus or minus the standard deviation. In other words, 32% of the time, we can expect outliers where the daily return will be larger (which means a better return for your portfolio) or smaller (which means a low return or even a loss).
The 32% of outliers are both good and bad events, and if we only focus on the downside, or the outliers where we expect less than the average return minus the deviation, it will only happen 16% of the time. This number is important to keep in mind, because this defines our boundary for the risk.
In finance, the standard deviation is defined as the volatility, hence when traders talk about high volatility, they mean that the daily returns are outliers compared to their historical average.
The standard deviation or volatility is therefore the risk. Indeed, it means the deviation from the average return, hence the level of surprise or fluctuation an investor might expect from the performance of an investment portfolio. Risk on your long term investment portfolioNow that we know what risk is, and what it means, let’s have a look at how it translates into your portfolio. Figure 2 shows an example of a retirement portfolio based on an annual return of 6% using the Risk Manager.
Figure 2
At the age of 85, based on this simulation, I expect to have $ 1.1 million. Based on a $ 1.1 million expected wealth at the age of 85, I should feel quite comfortable! However, as mentioned before, this is based on a flat return thus there is room for downturns, bull runs and even market crashes. So what are the risk boundaries for my portfolio, or what is the probability that I hit 0 before the age of 85?
Well, figure 3 shows you the risk boundaries for one standard deviation, this means that there is 16% probability that I have more than the upper bound in the graph, a quite optimistic point of view, and of course there is also 16% probability that I get less than the lower bound in the graph. Now this is worrying, because there exists a probability of a 16% chance of hitting 0 before the age of 85, and on top of that. I had earlier anticipated that achieving a $ 1.1 million buffer at age 85 would be a near total guarantee of worry-free retirement!!!
Figure 3
This is exactly the problem with investments, it is risky. Luckily, there are ways to improve the risk level of a portfolio, one of them is diversification. Another way to avoid the probability of ruin is to invest more over time, and to keep on investing in your portfolio as long and as much as possible. However, the key message is not to invest in a too risky portfolio, as you now know that bad surprises can happen.
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