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 28.9% and a loss of 8.5%. 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 13.3% and a loss of 2.1%.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.
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