When you invest in the stock market, you have to decide whether your potential gains are worth your possible losses. Some people can shrug off a 20% loss, while others shout, "I'm ruined!" when they lose $10.
If the stock market's recent gyrations have started your left eye twitching, you may own investments that are too risky for your disposition. How can you find a mutual fund that fits your risk tolerance? A few useful statistical measures can help you decide. But, ultimately, your tolerance for pain is the best gauge.
Analysts break down risk into several categories. Opportunity risk, for example, refers to the chance of missing out on something good, such as that last big stock rally. Event risk refers to the possibility of something going horribly wrong, such as finding winged goats perched outside your biotechnology lab.
But when we talk about risk and the stock market, we generally mean, "How much money do I stand to lose?" Dan Wiener, editor of the Independent Advisor for Vanguard Investors newsletter, favors a risk measurement called "maximum drawdown." It shows you the very worst period, from peak to trough, in a fund's history. For the Vanguard 500 Index fund vfinx, that would be a 44.8% loss over 25 months. The fund needed 50 months to recover.
Maximum drawdown isn't a figure that most funds disclose, though it would be nice if they did. If you want a good idea of a fund's worst performance, take a look at its record in 2002, a kidney stone of a year. The Vanguard 500 Index fund plunged 22.2% that year. If the thought of seeing $10,000 turn into $7,780 turns your blood cold, then you need a tamer fund. You can find the 2002 record for many funds at www.morningstar.com.
Morningstar (and the fund companies themselves) also produce several statistical risk measures that are worth reviewing:
•Standard deviation measures how much a fund's returns have varied from its average return. It's a useful measure of your fund's volatility. As a rule, 68% of a fund's returns will fall within one standard deviation of the average, and 95% will be within two standard deviations of the average.
Consider the Vanguard 500 Index fund, which has returned an average 7.05% a year for the past 10 years. Its standard deviation for that period is 15.06. About 68% of the fund's returns fell within one standard deviation of the average — 22.1% and -8%. About 95% of the fund's returns were within two standard deviations of the average — 37.2% and -23%. If you can't bear the thought of a 23% loss, you probably should look for a tamer investment.
The higher the standard deviation, the more a fund's returns vary from the average. Domestic stock funds in Morningstar's database have five-year standard deviations that range from a staid 1.95 for Gabelli ABC to an alarming 49.24 for Profunds Semiconductor UltraSector fund smpix.
The drawback to standard deviation: It tells you the range of returns during a particular period in the past. Things can always get worse (or better) in the future. We should note, too, that a high standard deviation is a lovely thing when the fund goes up.
•Beta refers to a fund's relationship to a benchmark, such as the Standard & Poor's 500-stock index. A fund that rises and falls in lockstep with the index has a beta of 1. A fund with a beta of 0.8 will rise and fall about 20% less than the index; one with a beta of 1.2 will rise and fall 20% more than the index.
Which index you use matters quite a bit. A small-cap fund's beta, for example, will be far different when calculated against the S&P 500 than against the S&P 600 small-cap index. It's a useful gauge either way, but you should know which index is used to calculate a particular fund's beta.
•Alpha shows how much — or how little — return is generated, given the risk a fund takes. A fund with an alpha greater than 0 has returned more than expected, given its beta. In other words, its manager has added some decent return without increasing its risk. A fund with negative alpha is producing a lower return than you'd expect, given its risk.
•Sharpe ratio, named after its originator, Nobel laureate William Sharpe, measures returns, adjusted for risk. Higher is better. Sharpe ratios for domestic U.S. funds range from a high of 2.74 to a low of -2.60, according to Morningstar.
Ideally, you should seek a fund with a beta of less than 1 and an alpha of more than 0. Five large-company stock funds with high alphas, low betas and above-average returns are in the chart.
Ultimately, the best measure of risk is how you feel after a dismal day in the market. If you weep every time the Dow falls, you might consider something a bit less volatile — such as bond funds or bank CDs.