Learning To Live With Risk And Loving It

There's no way around it: In the world of investing, risk goes hand in hand with returns. You'll need to assume many kinds of investment risk to achieve long-term goals, like saving for retirement or paying for a child's education. Yet instead of embracing risk and using it to their advantage as money managers do, individuals typically see risk as the enemy. "People are irrationally scared of it," says Jay DeMartine, head of marketing at Strong Funds. "It's like another word for bad."

Understandably, mutual-fund companies don't spend ad space extolling the risks of their funds. But several debacles last year--such as emerging-market funds crashing in December, or safe-sounding short-term government income funds losing principal--have convinced the Securities & Exchange Commission that fund companies need to do a better job describing risk. The SEC's most controversial idea is to choose a single risk measure and require fund companies to provide it to shareholders. The industry has argued that all options for quantifying risk have limitations and could confuse investors. Instead, it suggests streamlining risk discussion in the prospectus and using charts and graphs.

INTIMIDATED. Industry members will continue the debate at their annual conference in Washington on May 17-19. But now, the SEC is interested in what shareholders think. It has asked the public for suggestions on how mutual-fund risk disclosure could be improved. You can obtain a questionnaire, which must be returned by July 7, by calling 800-SEC-0330.

There are many types of risk, but the SEC has focused on one kind: the risk of volatile returns. Academics have come up with many ways to calculate this, and the SEC is evaluating them to see which ones investors find most useful. When fund-searching, don't be intimidated by terms like beta, alpha, or standard deviation. You don't need to know how to calculate the numbers; fund analysts such as Morningstar Inc. and Value Line list most of them in their publications. Afd while the measures have limitations, they aren't hard to grasp. Use them to choose a fund after you've narrowed your search to a handful in the same class or see how your own funds stack up on risk.

Beta typically tells you whether your stock fund is riskier or tamer than the Standard & Poor's 500-stock index (or how your bond fund compares to a bond index). It works very well when you use it to assess diversified equity funds that follow the market, says Sheldon Jacobs, who reports beta in his newsletter, No-Load Fund Investor. But because it measures risk relative to an index, beta doesn't mean much if the benchmark isn't right. Gold funds are very risky. But since they don't move with the stock market, they tend to have low betas.

Alpha, which is derived from the same theory as beta, compares the fund's actual return to the one you would expect given the beta, thus checking whether the manager has added value. Like alpha, Sharpe Ratio evaluates management's skill by seeing how much you were rewarded for the amount of risk taken. The higher the ratio, the better.

Standard deviation is the risk measure many academics prefer. It looks at how much a fund's returns diverge from its average return. Since it doesn't relate to any index, it can be used to compare funds from different asset classes. For example, based on monthly returns, the three-year standard deviation of the average U.S. diversified equity fund is 9.84 percentage points. Bond funds rate 5.15.

Standard deviation is useful because it can give a range of returns you can reasonably expect in a coming year. Returns for a fund with a standard deviation of 4 and an average return of 5% should fall between 1% and 9% two-thirds of the time. Some professionals argue that doesn't do you much good, since there's still a 1-in-3 chance the returns will be out of that range. Other critics point out that a fund that declines steadily month after month will have a low risk score, even though investors are losing money all the time.

MISLEADING. Since investors are mainly concerned with the risk of losing money, BUSINESS WEEK and Morningstar use a model that only takes into account investment loss. This measure looks at the amount a stock fund trailed the Treasury-bill return each month compared to the equity fund average (or muni funds to muni funds). But Stephen Savage, editor of Value Line Mutual Fund Survey, which uses standard deviation to calculate risk ratings, argues it's misleading to look only at the downside, since you can't achieve a high positive return without risk.

Of course, the simplest way to illustrate fund volatility is with a series of bar charts showing total return for each of the past 10 years. That's a move T. Rowe Price is making in its brochures and that the SEC also asks about in its survey. The problem is you can't use bar charts to compare different funds. T. Rowe Price is also starting to show a fund's worst quarter (assuming it was at least a 10% loss), so investors will recognize the potential for short-term losses.

There are some big problems with measuring risk based on historic returns. It certainly won't prepare you for major market events, like Mexico's meltdown, or last year's extraordinary bear market for bonds. If the fund changes managers or strategies, the historic performance may not be relevant. Also, "risk measures may not be typical if the fund isn't old enough," says Jacobs.

Ultimately, the ideal way to figure out the riskiness of a fund is to get inside the portfolio and examine the holdings. But since fund managers like to keep their strategies secret from competitors, the closest you can come is to glimpse a day's worth of holdings in the annual and semiannual reports. Morningstar and Value Line can help you get a handle on currency risk, derivatives, and, for bond funds, credit risk and average maturity.

For a year, some bond-rating companies have been assessing bond funds for risk. But sorting through the portfolio is time-consuming and costly, and only funds that pay for this service are rated. Plus, the National Association of Securities Dealers, which regulates fund advertising, recently decided these measures cannot be used in ads, since readers can interpret them as predicting future returns. Sanford Bragg, head of S&P's Managed Funds Group, says this "defies logic" when the SEC is trying to improve risk disclosure.

Even if the SEC finds a better way to disclose risk, an element of trust will always be necessary in mutual-fund investing. There are several ways to minimize risk when constructing a portfolio. Invest long-term, since that way you ride out cycles. Also diversify across asset classes. And you can reduce the risk that you'll put all your money in at the market high by dollar-cost averaging--investing a set amount of money at regular intervals.

Strong Funds' DeMartine says investors need to get over their fear of risk and look it "square in the eye." You'll need to learn how risk works in your portfolio. After all, if you want decent returns, you can't afford to run away from risk.

Risk By Definition

STANDARD DEVIATION Looks at how much the fund's returns vacillate each month from its average return. The higher the number, the more volatile a fund is.

BETA Measures how the fund has performed relative to a benchmark (the Standard & Poor's 500 index for stocks, Lehman Brothers index for bonds). A stock fund with a beta of 1 matched the market. A fund with a 1.1 beta did 10% better in up markets, 10% worse in down markets.

ALPHA Compares a fund's actual return to its expected return, given its beta risk. A positive alpha means the manager did better than the fund's beta would predict.

DOWNSIDE RISK Looks at loss risk based on how much a fund trailed the return you'd have gotten from a risk-free T-bill. Morningstar's (and BUSINESS WEEK's) measure expresses fund risk relative to the average fund in its class, which equals 1. A rating of 1.35 means a fund underperformed 35% more than the average fund.


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