volatility and standard deviation · 2019-10-18 · what exactly is volatility or standard...
TRANSCRIPT
Andy Ivory-Corr MSc, LIB, SIA, CFP®
Head of Investments
New Ireland Assurance
October 2019
Volatility and Standard Deviation LIA October 2019.
Measuring Risk
Measuring
Risk!
ESMA
Maximum
Drawdown?
Since March 2009, we’ve had little in terms of market volatility!
Warning: Past performance is not a reliable guide to future performance.
But 2% and 3% days are more common than we think!
Let’s be prepared for the potential return of higher volatility
Loss Aversion…………….
‘Research at an American university has
shown that the average person will be
2.5 times more upset about losing $10
than they will be happy about finding
$10’
When we create investment portfolios and recommendations for our clients under conditions of uncertainty, the consequences must dominate the probabilities!
Every time we consider an investment recommendation we should always remember the
facts on loss aversion!
Investment Offers no Free Lunch:
More Return = More Risk
Cash Deposits
Stocks &
Shares
Return
Ris
k
7
What does risk actually mean?
9
Risk profiling will help but can we define risk as a single number?
My client is a risk 3 – but what does that mean?
Volatility?
Volatility – is just a measure of Standard Deviation
Risk measures are now predominantly based around ESMA ratings as follows:
Volatility = Risk??
Risk is a complex concept…with no single perfect solution!
Clearly in this instance volatility does not necessarily equal risk!
Comparison of Volatility
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
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/05
/20
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Date
Un
it P
ric
e
Fund A
Fund B
‘Volatility’ is itself volatile and it can change over time!
Fund A
Fund B
!
Volatility – Statistics from our example
Daily Prices Fund A Fund B
Average move: 0.32% 0.76%
Max move: 1.6% 5.1%
Std. Deviation: 9% 15%
! Remember this is only telling us about what has
happened in the past and tells us nothing about what
might happen in the future!
The Funds to which stats relate?
Fund A: Balanced Managed Fund
(May 2003 to August 2005) = 9% would be ESMA rating 4!
Fund B: Balanced Managed Fund (January 2008 to April 2010) = 15% would be ESMA rating 6!
The problem? As the markets got riskier
so too did the fund! !
*ESMA ratings are calculated using 5 yrs historical data.
Chinese Proverb…….
• “it’s not the thing that’s the thing, it’s the thing behind the thing that’s the thing!”
• Chao Tsao….
Volatility – An Illustration!
Fund A Fund B
1 Year Return 6% 6%
January 0.5% 2.0%
February 0.4% -1.0%
March 0.6% 0.8%
April 0.8% 1.7%
May 0.8% -2.4%
June 0.7% 3.0%
July -0.2% 0.9%
August 0.5% 1.5%
September 0.5% -1.4%
October 0.5% -1.4%
November 0.5% 1.4%
December 0.4% 1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
Jan Feb M ar Apr M ay Jun Jul Aug Sep Oct Nov Dec Jan
Fund A Fund B
Q1 – Would you be happy
with this return?
Q2 – Would you invest more
with each manager?
We also need to know how ‘dispersed’ the data is, as well as the average return!
= 16
= 16
ESMA then categorises funds, by risk category depending on the historic volatility of the underlying fund. (Is this enough???)
What exactly is volatility or Standard Deviation?
• A measure of the variation of price of a financial instrument over time. (has many other uses outside of finance).
• The more volatile an investment is, the greater the variation of it’s returns (the higher the up’s and down’s of the investment are).
• Volatility does not measure the direction of price changes, merely their dispersion! (hence nobody minds ‘positive’ volatility!)
• So when we think about investment risk, what we are interested in is, the likelihood and size of ‘deviations’ from ‘expected or average’ return.
Some Terminology – Normal Distribution?
A normal distribution of data for anything being measured using Standard Deviation simply means
that most of the examples in a set of data are ‘close to the average’
Share Price BT – What observation would we make?
Warning: This information does not constitute investment advice or a recommendation. It has been provided for discussion purposes
only. You should seek professional investment advice with your financial advisor
Examining this graph we can see most of the movements are
clustered around the -2% to +2% with much fewer instances of -4% or +4% (lower probability!)
Warning: This information does not constitute investment advice or a recommendation. It has been provided for discussion purposes
only. You should seek professional investment advice with your financial advisor
Turning the graph we can see the pattern that gives us our ‘bell curve’ which is typically how Standard Deviation is illustrated!
Most of the returns are clustered
around -2% to +2% with much fewer to the left or right of
the graph!
Look how different the volatility appears depending on the timeframe under examination!
Warning: This information does not constitute investment advice or a recommendation. It has been provided for discussion purposes
only. You should seek professional investment advice with your financial advisor
Look at how dispersed returns can be over a 6 year period
Notice how this takes on the ‘bell shape’ again
Y axis is number Of data points for
Each value on X Axis
y
x
X axis is the values In question,
The percentage Gain or loss
So lets consider how we use this information!
• We must understand a few important points before we can use volatility to estimate risk.
1. The average return of the asset or fund in question.
2. The Standard Deviation of returns (volatility number)
Using Standard Deviation in finance is very different to other applications where the inputs are much more defined. Example would be getting the SD of the heights of everybody working in New Ireland – inputs are definite and not subjective!
Once we know these numbers we can apply the accepted probabilities to try to establish the risks!
AVERAGE
Example ESMA 3: Average Return 3%, volatility 4%
Mean or Average return
-9%
+11%
+7%
3%
-1%
-5%
+15%
-3sd -2sd -1sd +1sd +2sd +3sd
Standard Deviation and the bell curve in the real world!
Standard deviation tells us with a high percentage of probability, but not with absolute certainty!!!!
“The world we live in is vastly different to the world we think we live in”……..Nassim Taleb
Volatility can’t measure extreme events!
1. It can’t account for every eventuality in the market place, and extreme events can cause large ‘tail effects’ which fall outside normal ‘probabilities’
2. It assumes the returns of the underlying assets to be ‘normal’. As derivative structures don’t always display a normal distribution of returns, Standard Deviation may not be the best measure of risk within certain funds. (Hedge funds, Absolute return funds.)
3. It does not give you any measure of ‘risk adjusted’ returns.
Volatility the limitations as a measure of risk
It doesn’t take into account valuations, are assets cheap or expensive to begin with? (Bonds are low risk?)
Could underestimate the risk of some assets or funds, example Property. (7th October 14 – 7th October 2019 Volatility 3.9%) *Source Longboat analytics New Ireland Property Fund
Volatility can change over time. Important if you are building your own risk rated portfolios!
Not suitable for risk rating every type of investment fund, example Lifestyling!
Extreme events can’t be modelled with reliable statistics.
Volatility measures the past, but customers invest for the future!
Use models carefully, never retire your qualitative judgement!
Important Information Warning: The value of your investment may go down as well as up.
Warning: These funds may be affected by changes in currency exchange rates.
Warning: Past performance is not a reliable guide to future performance.
Warning: If you invest in these funds you may lose some or all of the money you invest .
Terms and conditions apply. Exit tax (up to 41% currently) applies to gains on life assurance investment policies. A Government levy (currently 1% of the premium amount) applies to all premiums paid to a life assurance policy. While great care has been taken in its preparation, this presentation is of a general nature and should not be relied on in relation to specific issues without appropriate financial, insurance, investment or other professional advice. The content of this document is for information purposes only and does not constitute an offer or recommendation to buy or sell any investment or to subscribe to any investment management or advisory service. While the information has been taken from sources we believe to be reliable, we do not guarantee its accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of publication and are subject to change without notice. State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered number 145221. Member of the Irish Association of Investment Managers. BNY Mellon Asset Management International Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorised and regulated by the Financial Services Authority. CP8083-08-03-2012(12m). BNY Mellon Asset Management International Limited, BNY Mellon Global Management Limited (BNY MGM), Newton, Insight, Walter Scott and any other BNY Mellon entity mentioned are all ultimately owned by The Bank of New York Mellon Corporation. Davy Asset Management is regulated by the Central Bank of Ireland. Kleinwort Benson Investors Dublin Ltd is regulated by the Central Bank of Ireland. Lazard Asset Management Limited, authorised and regulated by the Financial Conduct Authority. Incorporated in England and Wales, registered number 525667. Schroder Investment Management Limited is registered in England and Wales 1893220. Registered offi ce: 31 Gresham Street, London, EC2V 7QA. New Ireland Assurance Company plc is regulated by the Central Bank of Ireland. A member of Bank of Ireland Group.
October 2015
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Section Break Slide