MEASURING RISK

ACME's International Market Fund, touts a recent ad, has had average annual returns of 31.52%, 25.59%, and 11.78% over the past one, five, and ten year periods. While knowing past returns is great, what investors' should really be provided with is a proper measure of risk: what is the likelihood, say, of experiencing negative returns?

Enter the standard deviation, a statistical measure that helps quantify how much we can expect an investment to vary around it's mean. For example, take an asset that has an average annual return of 11% (such as the EAFE index from my previous post). Knowing that this asset has a standard deviation of about 20% helps us deduce that 68% of the time it's return will take on a value of 11% plus/minus 20% (assuming this asset follows a normal distribution) . In other words, there is a sixty-eight percent chance that it's returns will be between -9% and 31%. We can also infer that 95% of the time, returns will be the average plus/minus two standard deviations (or between -29% and 51%).

So how risky is investing in the TSX? Looking at the 1982 to 2006 period, the average annual return was 9.9% and it's standard deviation 17.9% (see table below). Consequently, 95% of the time we can expect returns to be between-25.8% and 45.6%. Risky enough for you?