Managed funds in New Zealand have to show a standardised risk indicator, which is a number from 1 (low risk) to 7 (high risk). You’ve likely seen it in fund documents and websites. It was first developed in Europe in 2010 and then adopted in New Zealand in 2015. But what really is it measuring? And can it help you manage your investment risk?
The risk indicator is a simple tool that measures the historical volatility of a fund’s returns. Volatility refers to how dramatically the price of an investment may change – if the price moves widely then we consider that investment has high volatility, but if it maintains a relatively stable price we say it has low volatility.
Think of volatility as being a measure of how steady and predictable a fund’s returns are (or not). A fund that invests in term deposits would have steady and quite predictable returns each month and so its volatility would be low. But a fund that invests in listed equities will rise and fall with the sharemarket, so next month’s returns could be quite different to last month’s, and so its volatility might be high.
The risk indicator is calculated off the fund’s monthly returns over the last five years. Without wanting to trigger bad memories of high school maths the risk indicator is the annualised standard deviation of those 60 monthly values. The number you calculate is a percentage, and then that percentage will map into one of the seven risk classes. For example, if the volatility was, say, 11% then that would be risk class 5, which is for percentages from 10% to 15%.
The attraction of the risk indicator is that it’s easy to calculate. It was developed by academics, and generally academics like to be able to reduce complex ideas like “risk” into a simple measurement. Whether that’s useful or not.
As investment practitioners, rather than academics, if we search for a practical application of the risk indicator then it is true that investors do have an emotional reaction to some volatility. If prices rise rapidly then that’s volatility, but generally we’re happy about it. But when prices fall rapidly, which is no different in terms of the maths behind the risk indicator, we all find that stressful. So perhaps the risk indicator is an indication of the level of emotional stress an investment might place on you.
But risk is a very complicated idea with multiple dimensions, and volatility isn’t one of the significant ones. In part 2 of this piece we’ll highlight some aspects of why the risk indicator is limited, and then later we’ll write about some of the ways we evaluate risk.