Risky business - determining risk and suitability for mutual fund investments
What is risk and how do we define it?
Many investors would presume that risk means the permanent loss of capital. This is true, of course. If you invested in a dot com stock that bombed several years ago you could have easily lost your entire investment.
Short of outright fraud, it is unlikely that anyone can lose all of their money investing in a equity mutual fund. This is not too difficult to understand as mutual funds usually have dozens of stocks in their portfolios. To lose all of your money, each of those stocks would have to go bankrupt.
Advisors, market regulators and investors all have different ideas about matching investments with an individual investor's risk tolerance, willingness to accept risk and other factors. The industry buzzword here is "suitability".
In the world of securities market regulators, low risk investments does not necessarily refer to low risk income, equity or balanced mutual funds, it refers to cash or money market funds – things that do not normally fluctuate in value. Some if not most investors, would think of cash as a no risk investment, however cash, is actually classified as a low risk investment. It could be that the regulators are saying that there is risk to everything we do.
They are correct of course. There is risk in everything.
One of the risks in the mathematical world of finance refers to fluctuation risk. A mutual fund that is fluctuating wildly to the upside could be considered risky. By definition, rapid and volatile price changes are considered to be “risky” because an investment that gyrates wildly (in price) to the upside could potentially do the same to the downside. Nobody protests about making money however the statistical definitions of “risk” do not take into consideration investor emotions when an investment starts fluctuating to the downside. All of a sudden, an investor's willingness to accept risk may change.
To a mathematician, the degree of price fluctuation or potential fluctuation can determine the mathematical “risky-ness” of a particular investment as measured by standard deviation or deviations away from the mean. This is the infamous "bell curve" so beloved by statisticians.
An investment that is making money for their investors and has a statistically low standard deviation (a low degree of fluctuation) over a long period of time could be reasonably considered to be a low risk investment; however there are problems with using these measures according to recent MFDA suitability guidelines. These measurements may not have any bearing on the willingness of an investor to accept risk. Therefore, mathematical ranking, statistical measures or weighted averages may not necessarily be acceptable according to the latest guidelines.
What other measures can be used to determine the riskiness of a mutual fund investment?
The prospectus of each mutual fund has a section that says or suggests what type of investor is best suited to their fund. Sometimes, the suitability wording there is somewhat broad and what is appropriate for a very broad range of investors may not be suitable for an individual investor's current situation. What if the performance of the fund does not match what it says in the prospectus? In the end, it is the advisor that must determine appropriate "suitability".
Although regulators enforce rules that help protect investors, many advisors think that some of the newer views about "suitability" could be open to abuse by a few unscrupulous investors who might adjust their suitability beliefs depending whether their investments are making money or not.
The federal government has been calling for the establishment of a single regulator to replace the many layered, multi-tiered regulatory framework that we have now. It is clear to many in the industry that sooner might be better than later.
[Editors note: The rules and regulations that govern mutual fund dealers and approved persons that work under the MFDA (Mutual Fund Dealers Association) jurisdiction can be found at http://www.mfda.ca/. It is a public web site (mostly) and is an interesting look into the complex world of mutual fund regulation.]