INVESTMENT STRATEGIES - RISK VERSUS RETURNS

Risk Versus Return

With any investment, there are two fundamental questions:

Is my money at risk?

What will my return be?

A basic fact of investing is that there is an inverse relationship
between these factors. If you want higher returns, you must take
more risk. Conversely, if you want low risk, you are limited to
lower returns.

Risk is difficult to quantify because it requires predicting the
future, something no one has managed to do with any success!
Unavoidably, risk is considered in terms of probability.
In other words, what's the chance I will lose some or all of
the money I have invested?

Take, for example, the safest investment—a bank savings account.
Because it is guaranteed by the U.S. government, it is as safe as
can be, but the returns are quite small. If you absolutely,
positively cannot risk losing a single dollar, this might be
the investment for you.

At the other end of the spectrum, consider a new Internet startup company.
A few Internet companies, such as eBay and Google, have gone on to make
huge profits for their investors. But for every successful Internet
company, 50 or 100 have failed, taking all their investors' money
down the tubes with them. This investment balances the likelihood that
you will lose most or all of your investment with the small chance
you will win big. Let's take a look at the relative risks of some popular investments.

As I have mentioned, bank savings accounts are as close to 100% safe as
you can get.

Money market accounts pay more return than savings accounts.
They are not guaranteed by the government and so, in theory,
could decrease in value, but this is very unlikely because it
would require a major financial upheaval. To my knowledge it has
not happened even once so far.

Bonds offer two risks. One is that the price of the bond will go down.
The bond market as a whole fluctuates with interest rates, with higher
rates meaning lower bond prices and vice versa. An individual bond will
decrease in price if the entity that issued it is in financial trouble.
Although it's rare, a bond can lose 100% of its value if the issuing
company goes bankrupt and defaults on its bond obligations. Bonds issued
by the Federal Government are the safest, followed by bonds issued by
Federal agencies and certain types of mortgage-backed bonds.
The bonds of large, established companies are the safest of the
nongovernmental bonds.

Stocks present a wide range of risk levels. Any stock can go down,
of course, and even the largest, most stable companies have historically
seen significant decreases in their stock prices. As a general but not
infallible rule, a company that pays dividends will experience less
stock price volatility than one that does not.

The risk of a mutual fund is tied directly to the risk of the various
stocks and/or bonds that it owns as well as to the investment strategy
of the fund. Generally speaking, a broad-based fund will have less risk
than a fund that specializes in a certain sector or country.
There are several popular measures of mutual fund volatility:

Beta is a measure of how the fund compares with a benchmark, usually the S&P 500. A beta of 1.00 means that the fund goes up and down in
lockstep with the benchmark. A beta of 1.15 means that if the benchmark
goes up or down by a certain amount, the fund goes up or down by 15% more.


Alpha is designed to improve on the beta ranking.
It compares a fund's historical beta value with its actual performance.
An alpha of zero means that the fund's performance was as expected
given its beta rating. A positive alpha means that the fund returned
more than expected, and a negative alpha means the reverse.

Correlation, sometimes called R-squared, is a measure of how closely changes in the fund's price mirror the changes in an underlying benchmark
index. R-squared can vary between 0 and 100, with higher values
reflecting a closer relationship between the fund's price and the index.

Standard deviation measures the tendency of a fund's
price to change quickly over a short period of time. A more general
term for this is volatility, but standard deviation more specifically
measures the fund's price fluctuations as a function of its long-term
return. For example, a fund that returned –6%, 2%, 18%, –7%, and 42%
for each of the past five years has an average return of 9.8% and a
relatively high standard deviation. In contrast, a find that returned
9%, 13%, 9%, 8%, and 10% also has an average return of 9.8% but has a
lower standard deviation.

Morningstar risk ratings are created by Morningstar,
a company that specializes in analyzing and reporting on mutual funds.
Values of less than or greater than 1 indicate less or more risk than
other similar funds (similar in investment goals and strategies).

As you can see, trying to get a fix on the risk of an investment is a tricky business that has stumped even the pros for years.