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.
Some 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.
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.
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 diversification 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. 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.
All of this can be simplified with our portfolio risk software, Riskalyze. This software can take all this data and compress it into a visual that provides you with a customized risk score and a potential range of returns. Find out what your risk number!
Note: Investing in mutual funds and stocks involves risk, including possible loss of principal. Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.