Reflections on the week ending June 13, 2010

As market volatility continues, I hear a heightened concern about the “risk” of investing in mutual funds.  In my opinion, this concern is substantially caused by “risk” being erroneously defined as “the standard deviation of price change”.  Sophisticated investors know that “the standard deviation of price change” is a measure of “price volatility, not risk”,  and seek to exploit price changes to acquire quality, low risk businesses at cheap prices. 

 To illustrate the point, consider the following two investment options:

1. A real estate property in which the investor directly owns a fractional interest; eg.  assume the investor owns 10% ($100,000) of a shopping mall that was purchased for $1 million and generates $100,000 in net rental income.  During the course of the year, the investor receives their share of net rental income.  The property is not revalued regularly and, accordingly, there is no price change, nor standard deviation of price changes.
   
2. The same real estate property is held in a publicly traded REIT which issued 100,000 units at $10 each.  The investor now owns 10,000 REIT units at $10 each.  The daily trading price of the REIT units fluctuates with a standard deviation of $0.50; i.e. one standard deviation is plus or minus $0.50, or 5%.  

The asset in both options is exactly the same.  Yet, Standard Deviation would suggest that owning publicly traded REIT units is more risky than owning the exact same asset through a non-publicly traded partnership interest.  How can that be correct?

An uninformed investor who sees rising price volatility of the REIT units may panic and choose to sell their investment at a lower price, thereby providing the sophisticated investor the opportunity to acquire a quality asset at a bargain price.

Recognizing the distinction between “standard deviation of price changes” and “investment risk” becomes especially important at a time like the present, when share price changes are quite high.  An obsessive focus on standard deviation is likely to increase the probability of long-term investors:

• selling otherwise high quality assets at the wrong time; and
• missing opportunities to acquire quality investments at discount prices.  

During the week, the following news items were of relevance to some of the companies we follow:

• On June 11, 2010, The Economic Times of India reported that “IT bellwether Infosys will hire 30,000 professionals this year as growth has returned to the sector, Chief Executive Kris Gopalakrishnan said here on Thursday.”  In related news, Reuters reported on June 9 that the President of India’s National Association of Software and Services Companies told reporters that India’s back-office outsourcing business will post a growth of 15-16% in the year to March 2011.  
• The main driver of growth for the wealth management sector is expected to be the need for Canadians to increase their accumulated wealth so as to protect their standard of living in retirement.  On June 10, 2010, TD Economics released a report that said, “Looking ahead, the share of retirees failing to meet the desired savings for 70% replacement is projected to rise from 15% for those born in the 1940s to just over 24% for those born in the 1980s.”  This shortfall will need to be made up through increased savings or higher returns.  Either way, the increasing need to increase wealth is good for wealth managers.
• On June 9, 2010, Invesco reported total Assets Under Management at May 31, 2010 of $430 billion, a decrease of 5.9% from April 30, 2010.