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.
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.1 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
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 1926-2020*
|*Based on returns for the period from 1926 through
2020. Stocks are represented by the total returns of the S&P
500 index. Bonds are represented by the total returns of long-term
U.S. government bonds, derived from the Bloomberg Barclays U.S.
Government Long index. T-bills are represented by the Bloomberg
Barclays U.S. Treasury Bill 1-3 Month 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 professionals 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 ensure 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 10.3% 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
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.