Most investment firms today use risk tolerance questionnaires with standard deviation being the primary method for helping to measure risk; here is why it's wrong.
The FinTech boom has equipped advisors with beautiful presentations and custom reports to prove why your investments are too risky and how you can easily de-risk your portfolio by hiring them. The concerning part is most firms aren't aware of the three key issues with the standard deviation metric (they are too focused on the beautiful presentations).
First, standard deviation is defined:
"standard deviation is a statistic that measures the dispersion of a dataset relative to its mean. The standard deviation is calculated as the square root of variance by determining each data point's deviation relative to the mean. If the data points are further from the mean, there is a higher deviation within the data set; thus, the more spread out the data, the higher the standard deviation." - Investopedia
Volatile stocks have a high standard deviation, while more stable stocks are relatively low.
All risk is calculated even when it's in your favor (the upside)
The core issue is the way risk is calculated using standard deviation and how you personally view risk.
There are three main issues, and most advisory firms are contributing to the confusion.
Standard deviation penalizes upside potential as much as downside drawdown.
Standard deviation does not measure risk the way you look at risk. Like most investors, your goal is to avoid losing money (or at least more than you can stomach). I've never met anyone who would be upset by unexpectedly growing their portfolio.
The upside and downside of your investment strategy should not be equally weighted.
Standard deviation assumes markets behave in a predictable or normally distributed manner.
With enough time and money, anything is possible -- we have neither.
Markets are anything but normal. Sure, with enough time to backtest and prove a point, anything can appear to be normal. The issue we all face is that our lives are everything but predictable.
Standard deviation distorts your understanding of risk.
Upside risk shouldn’t really exist; however, since standard deviation penalizes both upside and downside movements, it doesn’t accurately reflect how most investors view risk. This is similar to grounding one of your children because of how their sibling acted.
If you are like most investors, making more than expected is completely welcomed, it’s losing more than expected that’s the issue.
If this is more in line with your goals and mindset, downside deviation would be a more appropriate measurement since it only measures the risk of loss and won’t skew results for overcompensating on the upside.
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