Investing Articles |
Evaluating Investment Risk
What we don't know can hurt us. When it comes to investing, investing too conservatively for our goals can 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 h2 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, in any given month, there is a 67% chance that the annualized return for the S&P 500 will fall somewhere between a gain of 29.8% and a loss of 8.4%. As you can see, this is quite a wide range. At the same time, long-term treasury securities have a 67% chance of returning between a gain of 12.6% and a loss of 1.5%.
As you might expect, historically 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 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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|---|---|---|---|---|---|---|
| Stocks | Bonds | T-Bills | ||||
| Average | 10.7% | 5.5% | 3.8% | |||
| Best Year | 60.0 (1935) | 42.1 (1982) | 14.0 (1981) | |||
| Worst Year | -41.1 (1931) | -8.7 (1999) | 0.00 (1940) | |||
| Standard Deviation | 20.3% | 8.9% | 3.1% | |||
*Based on returns for the period from 1926 through 2007. Stocks are represented by the total returns of the S&P 500. Bonds are represented by the total returns on long-term Treasuries (maturities of 10+ years). T-Bills are represented by the total returns of 3-month T-Bills. Past performance is not a guarantee of future results. |
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Commonsense Risk Management
Despite the SEC's and the mutual fund industry's search for tools to explain investment 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 can probably afford more risk than a 65-year-old retiree. Your financial professional will pose questions designed to help you assess your risk tolerance. It's up to you to understand the risks involved in your investments.
Diversification
— Modern Portfolio Theory mathematically demonstrates 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.
Long-Term Investing
— If we go back to standard deviation, we see that volatility is greater over short time periods. Stock returns have averaged 10.7% since 1926. If you were a long-term investor, you would have experienced many steep climbs and a few steep drops, but overall you'd 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 while seeking long-term gains?
Dollar Cost Averaging
— If you are a long-term investor, dollar cost averaging can 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.
Dollar Cost Averaging does not assure a profit, nor does it protect against a loss in a declining market. This plan involves continuous investment regardless of fluctuation in price levels. You should consider your financial ability to continue purchasing through periods of low price levels.
Finally, perhaps the best advice is not to invest in anything you don't understand.
Points To Remember
- Return is a function of risk. In general, the higher the possible returns, the greater the volatility of those returns.
- The basic statistical measure of volatility is Standard Deviation.
- Beta compares an investment's volatility to a benchmark such as the S&P 500.
- Largest Monthly Loss and Down Market measures look at downside risk.
- Sharpe Ratio measures excess reward per unit of risk.
- Diversification, Long-Term Investing and Dollar Cost Averaging can help to reduce risk.
