1. Not just about stock markets
Investment Risks
Not just about stock markets

2. You can’t have one without the other
Investment
Risk
You can’t talk about investments without talking about risk; they go hand-in-hand. Regardless of the type of investment, there will always be associated risks.

3. International Investment Risk
Small Capitalization Equity Risk
Inflation Risk
Sector Risk
Manager Risk
Market Risk
Currency Risk
Credit Risk
Liquidity Risk
Interest Rate Risk
There are many types of risks that can affect the value of your clients’ investments. Market risk (stock market) is just one of them.
Just by quickly glancing at all the potential investment risks, it’s easy to understand how an individual can feel overwhelmed and confused. Without even understanding the meaning of each type of risk, just the sheer number of risk can be intimidating for an investor.
Securities Lending Risk
Income Trust Risk
Derivative Risk
Substantial Security Holder Risk

4. What does “risk” mean for clients?
For the majority of clients, the notion of investment risk is summed up in two words: losing money.
Many risk factors can influence the market value of a portfolio. But the first step is to determine what the client’s risk tolerance is with regards to fluctuations of the portfolio value.
Basically, what’s the biggest one-year loss is the client comfortable with?

5. Stay away from vague terminology
What level of risk are you comfortable with?
Low risk
Moderate risk
High risk
Does the answer to this question really give you a clear picture of the client’s risk tolerance? How do you know if the client’s interpretation of “moderate risk” for example is the same as yours?
For some, moderate risk means the possibility of seeing a 15% drop in value over a specific period of time while for others, it means a drop in value of only 5% over the same period of time.
What does it mean?

6. Stay away from vague terminology
Advisor Interpretation
Client Interpretation
Gap
The problem with using vague terminology to describe risk tolerance is that the client and the advisor may have a different interpretation of the same words.
If the advisor’s interpretation for a specific risk tolerance (i.e. low risk, medium risk, high risk) is different from the employee’s interpretation, it will inevitably result in frustration and stress.
The key when discussing risk tolerance is to be as precise as possible, leaving no room for different interpretations. It will then be easier to choose appropriate investment options and manage the client’s expectations.

7. Be precise 0% -5% -10% -15% -20% Other
What maximum drop in value over a one-year period are you comfortable with? 0%
-5%
-10%
-15%
-20%
Other
Since, for most clients, investment risk is equal to the possibility of losing money, establish with them how much they are willing to risk losing. This will give you a clearer idea on their risk tolerance.
Once you have established this, you can use the standard deviation of a fund, combined with the mean return to determine which investment funds is within the clients’ risk tolerance.
You, as well as your clients, will now know how big of a drop in value they can accept.

8. How can you determine which funds respect your clients’ risk tolerance
How can you determine which funds respect your clients’ risk tolerance? By using the standard deviation and the mean return.

9. Standard Deviation
Measure of variance that defines the risk of an investment by indicating by how much the actual return has varied from the mean return.
The higher the standard deviation, the higher the volatility. For example:
Money Market Fund 0,05
Fixed Income Fund 2,93
Balanced Fund 7,11
Canadian Equity Fund 11,87
How can you tell if the standard deviation is too high for a client?
We need to know what is the mean return.
The standard deviation by itself doesn’t tell us much. To give it more meaning, we must know the mean return of the same investment.
By looking solely at the standard deviation, it will be subject to interpretation which could lead to frustration and confusion for the client.

10. Standard Deviation Mean return
Before going any further, let’s look at how to interpret a standard deviation.
First of all, we must determine the mean of the data for the period of time studied. When it comes to investments, we’ll usually look at the mean of one-year returns (rolling one-year returns). The mean return is different from the annualized compounded return.
If the annual returns follow a normal distribution, as illustrated by the bell curve in this slide, it indicates that 68% of the annual return data fall within one standard deviation above or below the mean return.
To cover 95% of the data, we have to subtract or add 2 standard deviation to the mean return.

11. Getting back to the risk tolerance question
What maximum drop in value over a one-year period are you comfortable with? 0%
-5%
-10%
-15%
-20%
Other
Let’s look back to the question about the maximum drop in value with which the client is comfortable.
Suppose that the client’s answer is -15%.

12. Interpretation of standard deviation for investments
Mean Return
Standard Deviation
One standard deviation = 68% of annual returns (approx. 2 years out of 3)
Two standard deviations = 95% of annual returns (approx. 19 years out of 20) A
4.0%
5.0%
-1.0%
9.0%
-6.0%
14.0% B
6.0%
10.0%
-4.0%
16.0%
-14.0%
26.0% C
8.5%
15.0%
-6.5%
23.5%
-21.5%
38.5% D
20.0%
-10.0%
30.0%
-30.0%
50.0%
When evaluating investment options, it is better to use two standard deviations because it covers much more of the historical data. If you use just one standard deviation to determine if an investment option respects the client’s risk tolerance, there’s a likely chance of a nasty surprise for the client because one standard deviation covers only 2 thirds of the historical data.
Based on the historical performance of the investments, options C and D would not fall within the client’s risk tolerance.
Source: « La relation entre risque et rendement », Objectif Conseiller, juin 2010

13. Standard Deviation example – 5-year period
Funds
Standard deviation last 5 years
Average of rolling one-year returns for the last 5 years
Minimum and maximum annual return based on 2 standard deviations (95% of the data)
Minimum
Maximum
Fixed Income
3.07
4.96
-1.18
11.10
Growth & Income
12.15
-1.03
-25.33
23.27
Monthly Income
9.25
5.20
-13.30
23.70
Canadian Small Cap.
22.85
8.29
-37.41
53.99
Let’s look at an example.

14. Standard Deviation – 10-year period example
Funds
Standard deviation last 10 years
Average of rolling one-year returns for the last 10 years
Minimum and maximum annual return based on 2 standard deviations (95% of the data)
Minimum
Maximum
Fixed Income
3.23
4.00
-2.46
10.46
Growth & Income
9.63
4.94
-14.32
24.20
Canadian Small Cap.
18.02
13.95
-22.09
49.99
Same example, but it covers a 10-year period.
For the funds that have exposure to the stock markets, the data shows that the standard deviation is lower for the 10-year period compared to the 5-year period.
These differences illustrate that using the standard deviation to determine if a fund is adequate for the risk tolerance of a client is not a perfect approach. Depending on the period of time covered by the statistics, the results vary.
The difference between the 5-year table and the 10-year table is that some annual returns that fall within the 95% of all the annual returns recorded over a 5-year period fall outside of that same 95% of data for a 10-year return.
Source: PalTrak, Morningstar Canada

15. Using the standard deviation to compare similar funds
Such information is available on company websites or on public sites such as
If you don’t do a detailed analysis using the standard deviation and mean return as we just covered, you can still find information on investment funds’ standard deviation on company websites or public websites such as
When you compare two funds that are in the same category, in addition to the past performance, you can compare the funds’ volatility by looking at the standard deviation to see if there is a big difference.

16. First Example
Two funds in the same category with similar volatility but a different return.

17. Global Fund Global Dividend Fund Source: www.globefund.com
When we compare these two different funds from the “global equity” category, we notice that there isn’t a big difference with regards to volatility on a 3-year period. However, there is a notable difference in the 3-year return. In this case, in makes for an easier choice between the two funds.

18. Second Example
Two funds from different categories with a similar past performance but a different volatility level.

19. Canadian Small Cap. Fund
Balanced Growth Fund
Canadian Small Cap. Fund
Source:
When we compare these two funds, we can see that the 3-year return is similar. However, there is a notable difference in the volatility level for the same period because one of the funds is a small / mid cap equity fund which is more volatile than the other Canadian equity fund (Balanced Growth).
In this case, it is important to take into consideration the volatility level to ensure the client’s risk tolerance is respected before recommending a fund.

20. Standard Deviation
The use of the standard deviation and mean return helps in the selection of appropriate funds with regards to a client’s risk tolerance.
Gives the clients a clearer picture of the potential drops in value and helps prevent selecting investment options that exceed their risk tolerance.
We recommend that you use at least two standard deviations in your analysis.
Past performance may not repeat itself.
In reality, the distribution of rolling one-year returns do not follow a normal distribution.
For point no. 2, it’s also a good way to manage clients’ expectations.
For points 3 and 4, put simply, it means there could still be surprises.
For the last point, this means that there could be more annual returns that are below the mean return or that are above it. In other words, clients could see lower or higher annual returns than the minimum and maximum returns established by using 2 standard deviations (subtracted from or added to the mean return).

21. What’s the biggest risk for the client?
Possibility of losing money Possibility of not reaching their financial objective

22. Objective not attained
Starting Point
Which scenario has the biggest negative impact on the client’s financial plan: not reaching an objective or the periodic drops in investment value?
While it’s important to consider the client’s risk tolerance when recommending an investment option, you must also if the expected return of the chosen investment option will be sufficient to reach the client’s financial goal.
If, by being too conservative, the client does not reach his goal, will he be satisfied?

23. Reaching a Goal and Risk Tolerance Investor’s Risk Tolerance
Investor’s Goal
Investor’s Risk Tolerance
The fund that matches the client’s risk tolerance has an expected annual return of 4%.
GAP
To reach the goal at a specific date, the annual return must be 7%.
Here’s an example of a situation where there is a gap between the client’s financial goal and the fund that respects his risk tolerance.

24. Guide to help your clients make a decision
You should address the gap before making an investment recommendation.
What does your client prefer?
A combination of these solutions can be applied. S T E W
Save more
Take less (smaller goal)
Earn more (return)
Wait (reach goal later)
By addressing the gap between a client’s financial goal and his risk tolerance, you will prevent much frustration and stress for your client (and yourself) by managing his expectations.

25. Other risks not associated with stock markets
EMOTIONS
Some of the risks to a client’s investments are his own actions (or non-actions).
We can refer to them as behavioral risks.

26. Investments and emotions
They don’t mix well!

27. The cycle of market emotions
“I should get in now!”
Excitement
Denial
Hope
Anxiety
Optimism
Panic!
When emotions dictate when to invest in the market and when to get out, disaster can occur. That’s because, for most people, human emotions tend to want to invest after a few good years of returns, after having missed the most of the positive return.
And then, during market declines, emotions tend to make us get out of the market around the market bottom, not being patient enough to wait and profit from the next rise in the market.
Being out of the market, emotions tend to tell us to wait a while when markets start rising again to make sure it lasts. After a certain period of positive returns, emotions make us comfortable to invest in the market at that time, and the vicious cycle starts again.
Correctly timing the market everytime is impossible, and it leaves too much room for emotions which can lead to disaster.
This S&P TSX Composite index chart which is correlated with the price of oil shows its index level reaching a high above 15,000 points by mid 2014 when the price of crude reached 100$USD per barrel. The oil crisis began in late 2014, followed by a decline in the index.
“I’m getting out!”
Source: Bloomberg

28. Decisions based on emotions=
Too many transactions
The Terrance Odean study
Group A
Group B
Group C
Group D
Group E
Most frequent transactions
On average, Group A underperformed Group E by 7% per year.
Terrance Odean is an American Expert on Behavioral Finances.
His study was done in the 90s. He observed thousands of individual brokerage accounts and analysed the transactions within these accounts.
Source: “Buy and hold”. The same article was published in the Advisor’s Edge Report in July 2008.
Less frequent transactions

29. Other risks not associated with stock markets
PROCRASTINATION

30. Time is an investor’s best friend. A story about two investors…
To better explain the concept of time and its impact on investments, let’s look at the following story.

31. Time is an investor’s best friend.
Similarities
Average annual return of 6.00%
Total amount invested over time: $36,000

32. Time is an investor’s best friend.
Differences
Investor A:
Investment period from age 30 to age 60
Monthly investment = $100
Investor B:
Investment period from age 45 to age 60
Monthly investment = $200

33. What will be the outcome?
A) - Both investors end up with the same market value at age 60. B) - Investor A will have more money at age 60 than investor B. C) - Investor A will have more money at age 60 than investor B.
Multiple choice question. Ask the question and wait for an answer from the participants. Go to next slide to see the answer.

34. Time is an investor’s best friend.
The Big Difference
Investor A:
Market value at age 60 = $100,451.50
Investor B:
Market value at age 60 = $58,163.74
To get the same end result as his friend, Investor B would have to invest $ per month for a total of $62,173.80
After all information is shown on slide:
As you can see, even if both investors invested the same amount of $36,000, the fact that investor A started sooner made a big difference in the end. Typically, the longer your money is invested, the more return it earns which compounds year after year, giving you a higher end result.

35. Time is an investor’s best friend.
Another example with a 6% annual return
Investor A
Investor B
Investment Period
From age 30 to 45
From age 45 to 60
Monthly Investment
$200.00
Total Investment
$36,000.00
Market Value at 60
$139,392.79
$58,163.75$
Required Investment to Match Investor A
---
$479.31
Here’s another example of the benefit of time. In this case, each investor invests $200 per month for 15 years. The only difference is that Investor A invests from age 30 to age 45 and then stops, leaving his investment to grow until age 60. Investor B only starts to invest at age 45 and does so until age 60.
Again the difference is quite notable in favour of Investor A.

36. Other risks not associated with stock markets
INFLATION

37. The more the goal is long-term, the more impact inflation will have in the plan to reach that goal.
For retirement plans, since retirement can last many years, inflation can have a devastating effect if it wasn’t taken into account in the plan.
People hear about inflation but seldom understand the actual impact on their retirement income over many years. The effects of inflation, among other things, need to be taken into consideration when making investment choices at retirement.
Since the 1990s, the Bank of Canada’s objective is to keep annual inflation between 1% and 3%. But even a low rate of inflation will erode purchasing power over the years.
Source: Viewpoint, Lifetime income planning, Fidelity Investments

38. Risk Tolerance and Inflation
Index
1 year
3 years
5 years
10 years
FTSE TMX 91 day Treasury Bill Index
0.5%
0.8%
0.9%
1.6%
*As of June 30, 2016
It is true that “secure” investments such as shown in the table above do not have market risk and very low, or no, volatility (i.e. negative returns).
However, if the investment return is lower than the inflation rate, it results in a negative net return.
Inflation is a type of risk that must be accounted for when determining an investment strategy to reach a financial goal.
Be careful. Being too conservative with an investment strategy can be risky.
A strategy with no market volatility does not mean that it is without risk. Inflation risk is present in most, if not all, conservative investment options.

39. In conclusion…
There are many investment risks: some technical, others behavioural in nature.
It is important to clearly establish clients’ risk tolerance before recommending and implementing an investment strategy.
Determine if there is a gap between the risk tolerance and the financial goal and help clients make choices that will eliminate this gap.

40. Questions