It is always great to enjoy New Years Eve with friends and family. This years’ festivities were highlighted by a real desire to see the end of what has been a very trying year for just about everyone I can think of. The only thing in doubt for our Canadian equity market, the S&P TSX,  on the last trading day was whether-or-not we would beat 1931 as the worst percentage return year on record. A 100 point down day would have captured the dubious honour. We avoided this ” insult on injury” finishing 150 points higher, down about 33% for the year .

In the investment industry, risk is usually defined as volatility or differences in return experience when compared to the average expected value. If monthly returns are plotted, we would expect most values would cluster around the middle -  average value of  about one percent with progressively fewer values as we move away from the average.  This normal distribution would imply that values outside plus or minus 10%  should occur a couple of time every 100 years.   The stock market is different. There are many more large numbers – both positive and negative. Behavior finance experts explain some of this experience in term of investor psychology. In statistical terms this is a fat tail distribution. More values  appear at the extremes and the average value is less descriptive of actual experience. In 1987 the Dow dropped 23% in one day. That shouldn’t happen in our lifetimes, but it did.

Individual stocks are much more volatile than broad markets. The returns are similar, you just capture more risk to get similar returns and there is a big cost to getting it wrong. Yet risk to these approaches is often defined in terms of average volatility to broad market indexes. This is very misleading and causes a good deal of unnecessary confusion when portfolios don’t perform as advertised. It seems to me that an important part of our job as investment advisors is to minimize risk. We don’t try to manage money for improbable events, even if it would have worked last year. We mange assets so as to capture expected return with the highest probability of success. Fat tails shouldn’t alter that effort.