Many investors felt like they had nowhere to hide last year. Investment types that many thought might offer shelter in inclement weather for the stock market - such as bond funds and commodities - posted painful losses. Such blow-ups highlight the facts that investing comes with risks and that some investments are riskier than others. Identifying those risks, in addition to figuring out how much you are willing to tolerate, is one of the most important aspects of long-term planning.
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Understanding risk and setting your threshold
David Kathman
23 August 2009
Many investors felt like they had nowhere to hide last year. Investment types that many thought might offer shelter in inclement weather for the stock market - such as bond funds and commodities - posted painful losses. Such blow-ups highlight the facts that investing comes with risks and that some investments are riskier than others. Identifying those risks, in addition to figuring out how much you are willing to tolerate, is one of the most important aspects of long-term planning.
Unfortunately, there is no single definition of risk that works for everybody. But there are some key measures that will usually give you a good approximation. They are not perfect - hidden risks are often lurking - but they are better than guesswork.
Backward-looking risk measures
The world of finance is replete with measures that try to gauge how risky an investment has been in the past. In this context, risk is often equated with volatility, and the most common way to measure the volatility of a mutual fund (or any portfolio) is standard deviation. This measures how widely the fund’s monthly returns have varied over some period of time, usually three, five, or 10 years. If monthly returns have been very consistent, the standard deviation will be low, while if they have been all over the map, the standard deviation will be high.
One problem with standard deviation is that it does not have a lot of meaning without some context. Some types of funds are inherently more volatile, so a fund’s standard deviation can only be reasonably compared with those of its peers. Sector funds are more volatile than diversified stock funds, which in turn are more volatile than bond funds, and within each of these broad groups there’s a lot of variation.
Another potential problem with standard deviation is that it treats big gains and big losses (in industry parlance, upside and downside volatility) the same. But most investors are more concerned with downside volatility - the possibility that a fund will lose money or greatly underperform its peers. One measure that takes this difference into account is the Morningstar Risk score, part of the Morningstar Risk-Adjusted Return that helps determine a fund’s Morningstar rating. The details are rather complicated, but basically this measure uses a “utility function” that penalises downside variation more than it rewards upside variation.
Portfolio risks
Both standard deviation and Morningstar Risk are backward-looking risk measures - that is, they are based on how a fund has performed in the past. That can certainly be useful, but most investors are more interested in what a fund is likely to do going forward. Obviously we cannot know for sure how a fund will perform, but it is still possible to look at its strategy and current portfolio and get some idea of what kinds of potential risks a fund is likely to face.
One factor to keep an eye on is concentration. Funds that concentrate their assets in relatively few holdings - say, fewer than 30 for stock funds - can suffer in the short term if just one or two of those holdings run into problems. Such concentration risk is separate from standard deviation and Morningstar Risk, and it is often present in funds that we like.
For example, Janus US Twenty has compiled a very good long-term record with a concentrated portfolio of 20 to 30 stocks. However, its standard deviation is in line with its typical peers because of the managers’ long-term focus, but its concentrated nature has made performance quite streaky, so it has typically ranked near either the top or the bottom of the large-growth category.
A related type of risk arises from sector concentration, especially when these are volatile sectors such as technology. The most obvious example of this is sector funds, which focus on a single sector, but there are also quite a few funds that are nominally diversified but still pile into one or two sectors that can wreak havoc with returns.
Yet another type of risk to watch out for in stock funds is geographical concentration, especially concentration in relatively risky areas such as emerging markets. Emerging-markets stocks have been red hot for the better part of this decade, and funds with a lot of emerging-markets exposure have done very well.
Besides equity funds, bond funds also feature similar portfolio-based risks. Until the subprime mortgage crisis hit, high-yield bonds and emerging-markets bonds were on a great multi-year run, much like emerging-markets stocks, and bond funds with a lot of high-yield exposure relative to their peers generally did very well. While the great returns of funds with high exposures to high-yield issues may have looked attractive and even benign at first glance, there was plenty of risk lurking in those portfolios, as the subprime mess illustrated all too clearly.
Operational risks
Another area worth touching on for mutual fund investors concerns operational risks, which have to do with how a fund is run. For example, the risk that a manager might leave a fund is certainly something to consider, and that risk is much higher in some cases than in others. For example, Fidelity sector funds are well known for high manager turnover (though they have got better recently), while Henderson has managers in place for a decade. The risk of new or higher fees is also worth considering, and here, too, some fund shops are much better than others.
What you can do
It is important to remember that no fund’s risk should be looked at in isolation. A fund that might look very risky all by itself could be a good fit in certain portfolios. For example, a fund with lots of technology holdings could complement a portfolio with heavy value leanings, and an emerging-markets fund could help diversify a portfolio consisting entirely of domestic stocks.
You might find you are taking on risks that you did not realise, such as a big weighting in technology stocks, or you might find that there is room in your portfolio for more risk. When all is said and done, it is important to remember that even the best fund managers can have streaky short-term performance, so it is best not to get too hung up on consistency.
David Kathman is a fund analyst with Morningstar
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