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Evaluating Investment Risk

What we don't know can hurt us. When it comes to investing, investing too conservatively for our goals may be just as damaging as investing too aggressively. How can individuals strike the balance between risk and return in selecting among different types of investments such as stocks, bonds, and mutual funds?

Measuring Fluctuating Values

The tendency of an investment to fluctuate in value is known as volatility. Many people tend to oversimplify volatility: They think an investment is risky if it can change in value and safe if it doesn't change. In reality, there are different degrees of volatility. In addition, volatility is affected by how long the investment is held. Moreover, an investment that doesn't fluctuate in value may still hold other risks.

Five Ways to Measure Volatility

Standard deviation is a statistical measurement that shows the likelihood of above- or below-average returns, as well as their distance from the average return. This is the classic "textbook" measure of volatility. What is being measured is how widely an investment's returns fluctuate over time. Looking over the long term, standard deviation provides strong evidence of the relationship between risk and return.

Adding and subtracting the standard deviation to the mean return gives us the range of returns that we could expect 67% of the time. For example, based on historical performance, in any given month, there should be expected a 67% chance that the annualized return for the S&P 500 will fall somewhere between a gain of 30.1% and a loss of 9.9%. As you can see, this is quite a wide range. At the same time, long-term government bonds would be expected to have a 67% chance of returning between a gain of 15.2% and a loss of 4.0%.1

As you might expect, stocks have both the highest level of volatility and the highest average annual return. Treasury bills, generally regarded as the most risk-free investment, combine the lowest volatility with the lowest average returns. In theory, a mutual fund with greater price volatility is more likely than other funds to show larger losses in the future. One problem with this measure is that it assumes that prices are normally distributed over a bell-shaped curve. In practice, they are not. Still, standard deviation can be a useful first step in determining mutual fund risk.

Beta measures volatility of a mutual fund compared to a benchmark (for instance, the S&P 500) that represents the market as a whole. The market is given a beta of 1. A fund with a beta higher than 1 would be more volatile than the market, and would therefore offer greater upside and downside potential. For example, a fund with a 1.2 beta should move 20% more than the market as a whole. If the market goes up 10%, the fund should go up 12%. Similarly, a fund with a beta of 0.8 would be less volatile and increase only 8% in a market that has increased by 10%. The same percentages would hold true if the market declines.

The problem is finding an index that represents many mutual fund portfolios. For example, the volatility of the S&P 500 has little bearing on a gold fund. Nevertheless, the simplicity of beta, a single number that is easily understood, has contributed to its popularity. Alpha, a related measure, represents the relationship of beta to performance over the past three years. Here we compare the fund's actual performance with the performance predicted by beta.

Largest monthly loss is the greatest decline in share price for a particular stock or fund for any one-month period. Unlike many measures, this one looks at the performance of the fund's portfolio. It does not, however, compare that return to the market.

Down market refers to the relative performance of a mutual fund during a bear market. Since downside risk is a great concern to many investors, comparing down market returns will indicate how quickly and effectively fund managers deal with inevitable market declines.

Sharpe ratio seeks to measure the relative reward associated with holding risky investments. The higher the ratio, the greater the return for the same amount of risk. With decreasing returns, as the ratio declines, so does the reward for assuming more risk.

Total Returns From 1926-2016*
Stocks Bonds T-Bills
Annualized Return 10.1% 5.6% 3.5%
Best Year 60.0 (1935) 42.1 (1982) 14.0 (1981)
Worst Year -41.1 (1931) -12.5 (2013) 0.0 (1940)
Standard Deviation 18.8 10.4 0.9
*Based on returns for the period from 1926 through 2016. Stocks are represented by the total returns of the S&P 500. Bonds are represented by the total returns of long-term U.S. government bonds, derived from the Bloomberg Barclays Long-Term Government Bond index. T-bills are represented by the Barclays 3-Month Treasury Bellwether index. Past performance is not a guarantee of future results, and it is not possible to invest directly in an index.
Source: DST Systems, Inc.

Common Sense Risk Management

Despite the SEC's and the mutual fund industry's search for tools to explain investor risk, the complexity of risk remains a daunting obstacle. There is no single number or ratio to provide a comprehensive and predictable result. The best thing for investors to do is to assess their risk tolerance based upon their goals, financial condition, time frames, and comfort levels. In addition to personal preference, there are several rules of thumb.

Choosing Investments to Fit Your Needs

Mutual funds are available that span the risk spectrum. Be realistic about your goals and the time you have to meet them. A single 22-year-old may be able to afford more risk than a 65-year-old retiree. Most investment advisors will pose questions designed to assess your risk tolerance. It's up to you to understand the risks involved in various investments.

Diversification -- Modern Portfolio Theory suggests that putting your eggs in a variety of baskets can reduce overall risks, even if all the baskets themselves are risky. One of the benefits of mutual fund investing is diversification through a wide variety of investments. Stock funds that concentrate either in a small number of stocks or in a single industry will generally experience higher volatility. That's why sector funds offer opportunities for increased returns along with increased risk. Keep in mind, however, that diveresification does not assure a profit or prevent a loss. 

Long-term investing -- If we go back to standard deviation, we see that volatility is greater over short time periods. Stock returns have averaged 10.1% since 1926.1 If you were a long-term stock investor, you might have experienced many steep climbs and a few steep drops, but overall you might be ahead. The questions to ask are: What is your time horizon? How much can you afford to lose in the short term? Can you afford not to pursue growth to outpace inflation? And how comfortable are you accepting short-term losses in pursuit of long-term gains?

Dollar cost averaging -- If you are a long-term investor, dollar cost averaging may be able to help reduce market timing risk. By investing regular amounts at regular intervals, your cost per share will average out over time. If you believe that the market will rise over the long term, then the expensive shares you buy at the top of one cycle will be offset by the cheaper shares you buy when the market corrects.

Finally, perhaps the best advice is not to invest in anything you don't understand.


1Source: DST Systems, Inc. Based on the total returns of the S&P 500 Composite Index, and by a composite of the total returns of long-term U.S. government bonds, derived from yields published by the Federal Reserve, and the Bloomberg Barclays Long-Term Government Bond index, from 1926 through 2016.

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