Not All Risks Are Created Equal

By Pauline Shum Nolan, PhD, Co-founder and CEO and Simiao Zhou, PhD and Director of Research

If you ask investment advisors to quantify risk, they are mostly likely going to refer you to a well-known statistical concept called standard deviation. Standard deviation in this context measures the dispersion of an investment’s returns over time.

However, two portfolios with the same standard deviation (and other overall risk characteristics) may have very different risk drivers. Consider the two portfolios in Figure 1 below. They have the same standard deviation. You can see by comparing the pie charts below that their risk exposure to various industrial sectors are very different.

 

April 2007 - March 2017


 

 

 

 

 

 

 

 

 

Even though over the 10-year period, there was a 137 basis points difference in annualized return between the two portfolios, depending on your sector outlook going forward, you may have a preference for one portfolio over the other, given the differences in sector risk exposure. Another consideration may be more personal. For example, if you work in the materials sector - meaning that your human capital is significantly correlated with the fortunes of that sector - you may want your financial capital to be less concentrated in materials sector risk. In this case, you would prefer Portfolio 1.

The same considerations apply if you look at the macroeconomic risk exposures of the two portfolios in Figure 2. Portfolio 1 is exposed to fluctuations in the price of oil, and it has a bigger exposure to the US dollar. Portfolio 2, meanwhile, has a much larger exposure to interest rates, but no statistically significant exposure to oil. Note that while both portfolios have 10% in the GSCI Commodity Index fund (ticker: GSG), the risk exposure to oil is diversified away in Portfolio 2 by the inclusion of Information Technology stocks (ticker: XIT). In Portfolio 1, however, the exposure to oil is reinforced by the presence of Canadian dividend stocks (ticker: CDZ), which has 19% of its holdings in the energy sector. So again, depending on your macroeconomic outlook and personal circumstance, you will likely have a preference for one portfolio over the other.

 

 

If you are looking for a low-cost, geographically diversified portfolio, there are inexpensive options from different providers, including recently launched fund of funds solutions. Bear in mind that they are one-size-fits-all solutions, and if you have specific risk preferences such as those discussed above, you will need a more tailored portfolio, but it does not have to be expensive either. The Portfolio Builders in Wealthscope can help you find the right one.

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[1] Portfolio 1 is made up of the following 7 ETFs: iShares MSCI Min Vol (Ticker: ACWV) 10%, iShares Canadian Dividend Aristocrats (Ticker: CDZ) 20%, Powershares Nasdaq 100 (Ticker: QQQ) 10%, Vanguard Small-Cap (Ticker: VB) 20%, iShares TSX Capped Financials (Ticker: XFN) 20%, iShares Gold Bullion CAD hedged (Ticker: CGL) 10%, iShares GSCI Commodity Index (Ticker: GSG) 10%.

[2] Portfolio 2 is made up of the following 7 ETFs: iShares MSCI Min Vol (Ticker: ACWV) 20%, iShares MSCI Emerging Markets CAD (Ticker: XEM) 20%, Powershares Nasdaq 100 (Ticker: QQQ) 10%, Vanguard Small-Cap (Ticker: VB) 20%, iShares TSX Capped Info Tech (Ticker: XIT) 10%, iShares Gold Bullion CAD hedged (Ticker: CGL) 10%, iShares GSCI Commodity Index (Ticker: GSG) 10%.​

Portfolio 1 [1]

Annualized standard deviation: 9.90%

Annualized return: 7.79%

Portfolio 2 [2]

Annualized standard deviation: 9.90%

Annualized return: 6.42%

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