Canadian regulators have within the last few years implemented a standardized measurement of risk which all firms that manage mutual funds must comply with. I would normally applaud this dedication to transparency and avoidance of risk, but alas I think the regulators have made a serious misstep in their choice of what constitutes risk. As a result, investors will not be as protected as they could be.

The definition of risk is a tough one to pin down because every individual is in a completely unique situation. What might be a risk to one person is less of a risk to another. There are also different kinds of risks which may or may not be important depending on the personal circumstances.

One of the most commonly used measurements of risk is measurements of volatility, or how much does the stock’s price move up and down. The more volatile the stock, the more risky it is perceived to be. There is some logic to this. Large stable and mature businesses tend to fluctuate a lot less than small junior mining companies. What is also true about volatility is that investors will be more likely to “bail” on a more volatile investment because psychologically it is tougher to hold on to then a more stable investment like a bond or real estate (at least on the surface they are more stable).

The most common measurement of volatility used, and the one which regulators have now selected is that of standard deviation. Standard deviation is a statistical measure which is used to quantify the amount of dispersion in a series of results. In plain English, standard deviation measures the range of possible returns. They do this by measuring the past returns and seeing how much they bounced around. A stock with annual returns over 3 years of +17%, -10%, +33% will have a higher standard deviation then a government treasury bond with annual returns of +4%, +1%, and +3%.

Using standard deviation as the base, the Canadian Securities Association has set categories of risk based on how high the stock’s standard deviation was. The categories they set are as follows:

Now most people don’t know what standard deviation numbers mean, but everyone can understand low risk or high risk. So by setting this standard, the CSA is saying that Standard Deviation is equal to risk and all an investor needs to do is check the fund facts where the standard deviation will be published to decide whether it’s a high risk or low risk investment. That would be very convenient, if it were true.

Unfortunately it’s not. Using standard deviation or any volatility measure as the only measure of risk has some major flaws.

For one thing, standard deviation relies on historical returns to predict future returns. “If a stock has not been volatile in the past it will not be volatile in the future”, goes the logic. To illustrate the absurdity of this, one need only look at the lives of farmed turkeys. Each day they wake up, eat, run around the barnyard and go to sleep again. If a turkey were a human being, they might be tempted to predict that this blissful life will go on forever year after year. After all, every day of their life has been exactly the same, and the more of those days pile up, the more sure they are that they will continue into the future. And of course their prediction would be proven correct, each and every day, up until the day before thanksgiving. The inability of a turkey to predict its own demise is not much different than an investor’s inability to sense the potential cliff their investment may be heading towards. What is certain is that past volatility would not give any indication of the turkey’s impending doom, and likewise it will not help an investor avoid catastrophe. Long term capital management and Bernie Madoff’s funds had very small standard deviations, and their investors nevertheless lost virtually everything.

Standard deviation has another problem. It has failed to define what true risk actually is. In my opinion, risk is the possibility of not achieving a financial goal you have set. For a normal investor who is just seeking to maximize their returns, risk is the possibility that their purchasing power in the future will be less than their current purchasing power. In other words, the risk is that they will lose money, after inflation is calculated in. If that is the measure then logically it follows that the lower price you pay for an investment, the lower risk it will be. Not so with standard deviation. If an investment had a long period of stable prices followed by a 50% drop of its value, the standard deviation measure would say that it was less risky before the drop in price, rather than after when it could be purchased for half the price. That doesn’t make any sense. How can an investment be less risky when it is more expensive? I would argue it can’t.

Another problem with volatility is that it sometimes fails to take into account that volatility can be a positive thing when it leads to higher absolute returns. Let’s take a closer look at my example above:

Looking at this chart, which was the riskier investment? Standard deviation measures would say that the stock was a much more risky investment. It would fall into the high risk category, while the bond would fall into the low risk category. Despite this, it’s clear that the stock delivered much higher absolute returns. If the stock was purchased at a large discount to its intrinsic value, I would argue that over a longer period of time, it would be the lower risk investment because it would be much more likely to deliver positive returns, after inflation is accounted for. You can see that at a 3% inflation rate, the bond has actually lost purchasing power over 3 years. This can be further extrapolated to a GIC. If the GIC pays a guaranteed 2% interest rate, but inflation is 3%, then the GIC is guaranteed to lose purchasing power every year, and therefore a GIC would be a much riskier investment than the stock in this example.

Now there’s no question that volatility needs to be guarded against in certain circumstances. If you plan to sell your investments and spend the money in the next year, you should probably consider a less volatile investment because there is a good chance that a volatile investment might go down in value right before you sell it. For those types of situations, bonds or GICs may still be the most appropriate, and you may even want to pick an investment based on a low standard deviation. However, as I’ve demonstrated, I don’t think standard deviation is very helpful in assessing risk in most cases, and I certainly don’t think it should be the only measure an investor should look at when assessing risk. The risk ratings which appear on a fund facts for a mutual fund are highly misleading to say the least. Investors need to look beyond the risk ratings they see on the fund documents they are provided with and ask their advisor what is the true risk of an investment, based on its purchase price relative to its intrinsic value, and its future prospects.