- 2.5% probability of failing to meet a return threshold may be acceptable for many clients.
- For normal distribution of returns, the probability of a return that is more than 2 st dev below the mean or expected return is ~2.5%
- So if we subtract 2 st dev from a portfolio’s expected return and the resulting number is above the client’s return threshold, the client may find the resulting portfolio acceptable. If it is below, the portfolio may be unsatisfactory.
- If client is more risk averse, you can choose a larger number for st dev. If client is less risk averse, choose smaller number.
Why is the bolded part true? This is from the book. If client is more risk averse, shouldn’t you want to choose a smaller number for st dev? You want there to be less chance of a negative return, and smaller volatility.