Putting Risk in Its Place in Your Portfolio: Part 1

Most investors see risk as the chance that they may lose money. But academics and statisticians, who have been studying risk in the financial markets for the past half-century, define risk as measurable uncertainty. And that additional notion "that risk can be measured" makes all the difference. If you can quantify risk, you can use the information to become a smarter investor. You can identify the securities you own that have the most risk. You can check your overall portfolio risk level and compare your risk against major indexes. Most important, you can change your portfolio risk level by combining investments that have different risk characteristics . if you (or your advisor) understand the nature of risk and how to measure it.

Types of Risk
In an ideal world, investors would be able to earn consistently high returns with no risk. But in the real world, all investments have some degree of risk associated with them. For example, if you invest in a stock, you are exposed to equity market risk, i.e., the chance that your investment will either gain or lose value simply because of what happens in the market itself. If you invest in a bond, you're exposed to interest rate risk, i.e., the chance that a change in current interest rates will either raise or lower the value of the bond you purchased. If you buy foreign stocks and bonds, you are exposed to currency risk on top of equity and interest rate risk because fluctuating currency values have an impact on performance when it is translated into U.S. dollars. In addition to specific risks associated with each asset class, most investments are also vulnerable to event risk, which involves an unexpected and sudden shock: a company's default on its loans, a product failure, a natural disaster, political upheaval or war. Even guaranteed savings vehicles such as certificates of deposit and savings accounts involve risk ? the risk that you could lose purchasing power because of rising inflation.

Measuring Risk with Standard Deviation
If risk is uncertainty, it stands to reason that investors would like to know just how uncertain their returns are going to be. Surely an investment that makes more and greater sudden moves is, by definition, riskier than one that plods along a more predictable path. Even two investments that earned the same return may get there in different ways. Take a stock that returned 12% for the year. Wouldn't your assessment of its risk be different if it achieved its return by soaring 20% one month and plunging 11% the next month than if it had gained a steady 1% a month throughout the year? That's where standard deviation comes in. Standard deviation is a statistical measure of how much an investment's returns vary from its mean. It measures an asset's volatility, how much up and down movement it experiences on the route to its return. Generally speaking, the higher the standard deviation, the riskier the investment (and we won't go into any more details for now).

Beta Can Be Even Better
While it is useful to know an investment's variability of returns, it's just as important to understand its variability in relation to other investments in the same asset class or style category. If you own two stocks with different standard deviations, you know the one with lower standard deviation is less risky. But wouldn't you really like to know how both stack up relative to the entire stock market? That's what beta will tell you. An investment's beta (formally, beta coefficient) is a measure of its volatility relative to a segment of the market, such as the S&P 500 or the Lipper Small Cap Funds Average. Beta is useful because it puts the volatility of an investment in the context of its peer group. Once you know that Yahoo!, for example, has a beta of 3.4 (while General Electric's beta is 1.1), you can decide whether you have a stomach for the inevitable volatility that comes along with owning a stock that is three times as risky as the overall stock market. Beta is a narrower measure than standard deviation since it reflects only the market-related portion of an investment's risk, but it can be revealing, especially if there is a high correlation between the asset and the index that is used for comparison. If the correlation, however, is less than about .70, then the asset's beta becomes worthless. The reason behind this will be explained next month when we talk about correlation.

Correlation Drives Portfolio Risk
While standard deviation and beta can shed light on the risk associated with individual assets, correlation is a key driver of total portfolio risk. Next week we will pick up on the most crucial, overlooked and least understood aspect of risk and of composing an efficient portfolio. I'm talking about CORRELATION.