Advisors Acknowledge Investors Cannot Fairly Evaluate Risk
In a survey of 50 advisors, and investment councilors from firms across Canada, advisors were asked two questions: ‘What percentage of your clients know the odds of losing money in their investments over the next year, and if there was a chance they could lose money, would your clients know how much money they could potentially lose?’ In 49 out of 50 interviews the answers were candid and surprisingly similar. Most investors cannot fairly evaluate the risk of their investments.
Hans Merkelbach, an advisor with Dundee Private Investors, well known for his outspoken support of disclosing accurate return and advisor compensation information to investors stated “I try to educate by regularly sending articles and letters to show clients what I’m trying to accomplish in their portfolios, but most clients could not answer those kinds of questions with any certainty.”
In a recent study conducted by Desjardins and published in the Investment Executive’s Special Supplement November 2005, almost 60% of surveyed Canadians believe they have limited or no knowledge about retirement savings or investments. The general consensus of the survey of advisors conducted by PureLogix Corp. in October of 2005 suggested a much lower number. According to advisors, perhaps less that 10% of investors have a clear picture of the risks they are exposed to.
These findings are partially confirmed by the Investment Dealers Association website. As of September 30, 2005, 1015 complaints had been received for the year. Out of all complaints received the IDA lists ‘unsuitable investments’ as one of the most commonly reported investor complaints. Although the IDA does fine a large number of advisors each year, the number of fines issued is a fraction of complaints received.
The discrepancy suggests the majority of advisors are filling out Know Your Client data adequately to satisfy investigators. If that’s the case, the only other reasonable conclusion that can be drawn is that complaint numbers are driven primarily by investor misinterpretation of risk.
Gamblers can easily find the odds of winning or losing a game of chance posted within casinos. Poker played on television calculates the odds of winning a hand in live time for the education of viewers watching the game. With something as important as investor life savings, why aren’t dealers providing tools to the advisors in the field to accurately disclose risk to investors?
Advisors interviewed cited many issues. First, the majority of investment dealers and investment council firms may not have the finances or expertise to develop adequate proprietary in-house systems. Second, there is a problem with awareness. Many dealers don’t realize excellent risk assessment technology can be purchased ‘off-the-shelf’. Others felt governance requirements were at the root of the problem. One advisor who asked not to be named said, ‘If investors aren’t demanding this kind of disclosure, then regulatory bodies aren’t interested in pursuing the issue even if it is the right thing to do.’
What can advisors and investors do to better understand the risk of investments if they don’t have access to software that calculates risk for them? Go back to your high school math text books and start applying basic statistics to evaluate risk. Using only a three year time-weighted return, a three year standard deviation and a basic calculator both advisors and average investors can start to get a better understanding of risk. Here’s how:
The basic premise when considering standard deviation is the bell curve. It’s not really important to know what the bell curve looks like or exactly how it’s calculated. What is important is knowing the statistics surrounding it. One standard deviation away from a security’s average return (known as the mean return) accounts for around 68% of all one year returns sampled in a three year period. Two standard deviations away from the mean return account for roughly 95% of all one year returns sampled in a three year period. Three standard deviations account for about 99% of all possible returns.
Let’s say for example, you are evaluating a security with a 10% 3-year compounded return with a 3-year standard deviation of 8%.[1] If a security’s average return is 10%, one standard deviation, or approximately 68% of the time an investor could expect the security to return a one-year return of between 10%+8% = 18% and 10%-8% = 2%. If we include 2 standard deviations, then 95% of the time an investor could expect the security to return a one-year return of between 10%+8%+8% = 26% and 10%-8%-8% = -6%. The remaining 5% of the time is where it gets a bit more critical. There is a 2.5% chance this security could produce a one year return in excess of 10%+8%+8%+8% = 34% or more. There is also a 2.5% chance this security could return 10%-8%-8%-8% = -14% or more. Admittedly, a 2.5% chance of losing 14% or more in one year is remote, but if an investor isn’t absolutely prepared to lose 14% or more of their life savings in one year, they really should be given the opportunity to ask their advisor to present a more conservative solution.
[1] Please note, that although the 3 year compounded return is not the mean return for the security, it is usually much easier to find than a three year mean return, and will suffice for rough evaluation purposes
Hans Merkelbach, an advisor with Dundee Private Investors, well known for his outspoken support of disclosing accurate return and advisor compensation information to investors stated “I try to educate by regularly sending articles and letters to show clients what I’m trying to accomplish in their portfolios, but most clients could not answer those kinds of questions with any certainty.”
In a recent study conducted by Desjardins and published in the Investment Executive’s Special Supplement November 2005, almost 60% of surveyed Canadians believe they have limited or no knowledge about retirement savings or investments. The general consensus of the survey of advisors conducted by PureLogix Corp. in October of 2005 suggested a much lower number. According to advisors, perhaps less that 10% of investors have a clear picture of the risks they are exposed to.
These findings are partially confirmed by the Investment Dealers Association website. As of September 30, 2005, 1015 complaints had been received for the year. Out of all complaints received the IDA lists ‘unsuitable investments’ as one of the most commonly reported investor complaints. Although the IDA does fine a large number of advisors each year, the number of fines issued is a fraction of complaints received.
The discrepancy suggests the majority of advisors are filling out Know Your Client data adequately to satisfy investigators. If that’s the case, the only other reasonable conclusion that can be drawn is that complaint numbers are driven primarily by investor misinterpretation of risk.
Gamblers can easily find the odds of winning or losing a game of chance posted within casinos. Poker played on television calculates the odds of winning a hand in live time for the education of viewers watching the game. With something as important as investor life savings, why aren’t dealers providing tools to the advisors in the field to accurately disclose risk to investors?
Advisors interviewed cited many issues. First, the majority of investment dealers and investment council firms may not have the finances or expertise to develop adequate proprietary in-house systems. Second, there is a problem with awareness. Many dealers don’t realize excellent risk assessment technology can be purchased ‘off-the-shelf’. Others felt governance requirements were at the root of the problem. One advisor who asked not to be named said, ‘If investors aren’t demanding this kind of disclosure, then regulatory bodies aren’t interested in pursuing the issue even if it is the right thing to do.’
What can advisors and investors do to better understand the risk of investments if they don’t have access to software that calculates risk for them? Go back to your high school math text books and start applying basic statistics to evaluate risk. Using only a three year time-weighted return, a three year standard deviation and a basic calculator both advisors and average investors can start to get a better understanding of risk. Here’s how:
The basic premise when considering standard deviation is the bell curve. It’s not really important to know what the bell curve looks like or exactly how it’s calculated. What is important is knowing the statistics surrounding it. One standard deviation away from a security’s average return (known as the mean return) accounts for around 68% of all one year returns sampled in a three year period. Two standard deviations away from the mean return account for roughly 95% of all one year returns sampled in a three year period. Three standard deviations account for about 99% of all possible returns.
Let’s say for example, you are evaluating a security with a 10% 3-year compounded return with a 3-year standard deviation of 8%.[1] If a security’s average return is 10%, one standard deviation, or approximately 68% of the time an investor could expect the security to return a one-year return of between 10%+8% = 18% and 10%-8% = 2%. If we include 2 standard deviations, then 95% of the time an investor could expect the security to return a one-year return of between 10%+8%+8% = 26% and 10%-8%-8% = -6%. The remaining 5% of the time is where it gets a bit more critical. There is a 2.5% chance this security could produce a one year return in excess of 10%+8%+8%+8% = 34% or more. There is also a 2.5% chance this security could return 10%-8%-8%-8% = -14% or more. Admittedly, a 2.5% chance of losing 14% or more in one year is remote, but if an investor isn’t absolutely prepared to lose 14% or more of their life savings in one year, they really should be given the opportunity to ask their advisor to present a more conservative solution.
[1] Please note, that although the 3 year compounded return is not the mean return for the security, it is usually much easier to find than a three year mean return, and will suffice for rough evaluation purposes
posted by Edward Iftody, BA, CIM at
3:21 PM
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