In sunny California at the head office of the IFA (Index Fund Advisors) there is a unique device that demonstrates how a normal distribution is created through the course of random events. The IFA commissioned this creation, christened the “Sir Francis”, to better communicate to investors the concept of market randomness and the probability of returns.
Based on a ‘quincunx’, otherwise known as a ‘(Sir Francis) Galton board’ or ‘bean machine’, the device drops balls through an array of pegs. The balls hit the pegs and bounce their way down to the bottom where they are collected in little bins. Each time a ball hits one of the pegs, it bounces either left or right, randomly.
Probability gives an equal chance of each ball bouncing left or right. Within a few minutes, enough balls will have reached the bins at the bottom to form the classic bell-shaped curve of a normal distribution. What makes this such a powerful illustration for investors is the striking resemblance to the distribution of 600 monthly returns (50 years) of IFA’s Index Portfolio 100, which, on the IFA’s board, is indicated by a red overlay.
The random distribution displayed by ‘Sir Francis’ shows how a high-risk portfolio carries a wide range of outcomes (or a high standard deviation) but maintains a normal distribution with about a 1.13% average monthly return over the last 600 months, but with much short-term volatility.
Mark Hebner, Founder of Index Fund Advisors and author of Index Funds: The 12-Step Recovery Program for Active Investors, wrote:
“We know that markets are moved by news which is both random and unpredictable and this news is rapidly incorporated into stock market prices. The degree to which your investment portfolio is exposed to the equities, and therefore vulnerable to equity market-moving news goes a long way to explain the expected range of outcomes the portfolio will experience. Investment portfolios with higher standard deviations have greater uncertainty of returns, but when properly constructed they carry higher expected returns. This relationship between an investment’s level of risk and its expected return is the classic economic trade-off.”
The historical data supports the presumption that investors who have higher risk capacities are expected to earn higher returns. In the field of finance, standard deviation represents the risk associated with a security (stocks or bonds), or the risk of a portfolio of securities.
As Dominic Lobo explained in his recent post on Modern Portfolio Theory, risk is an important factor in determining how to efficiently manage investments because it determines the variation in returns on the asset and/or portfolio and gives investors a mathematical basis for investment decisions. When putting together a portfolio it is not sufficient to focus on returns alone; risk must be considered as well. As risk increases, the expected return on the asset should increase as a result. In other words, investors should not expect a higher return on an investment without that investment having a higher degree of risk, or uncertainty of those returns.
It’s therefore crucial that investors understand their own tolerance to investment risk. Very few can afford or are comfortable with high volatility portfolios.
The calculation of the measure of portfolio risk in comparison to the market as a whole (market beta) may be somewhat complicated to grasp, but in fact it’s simple. A successful portfolio must be based on each client’s capacity for risk. To achieve this balance, we employ diversification. A well diversified portfolio captures the right blend of market indexes, avoiding the higher risk associated with individual stocks and bonds. It purports a measure of the market volatility itself, a risk that must be taken if you want market returns.
We’ve built our AstutePortfolios to make the most of this diversification strategy. At Quadrant Group, we don’t attempt to guess the next winner. We know that investors shouldn’t rely on stock picking, market timing, or the promises of a supposed market-beating fund manager. As a result of randomness, it makes sense to focus on probabilities. This methodology has withstood the test of time – as ‘Sir Francis’ so elegantly illustrates.
This article does not constitute financial advice. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner to take into account your particular investment objectives, financial situation and individual needs. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections.