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How to Measure Risk
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No matter how you invest your money, will assume some degree of risk. Generally, the higher the risk, the more you should be compensated for assuming that risk. But how do you measure an investment's risk?
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The most effective way is to look up its standard deviation. This measures an investment's volatility, or how much its returns have varied over time. For example, for a fund with a mean annual return of 10% and a standard deviation of 2%, you would expect the return to be between 8% and 12% about 68% of the time, and between 6% and 14% about 95% of the time. The higher the standard deviation, the more volatile, and thus the more risky, the investment. | |
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You can use Morningstar.com to look up the standard deviation of just about every investable fund. Among the information you will find is Morningstar's risk assessment. This measures the amount of variation in the fund's monthly returns in comparison with similar funds, with an emphasis on downward variation. This is emphasized as most investors are more concerned about possible poor outcome than an unexpectedly good outcome. The greater the variation in returns the larger the risk score. Possible scores are low risk, below average, average, above average, and high.
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Keep in mind, though, that any risk measure is based on past performance. There's absolutely no guarantee that a low risk fund, for instance, will not suddenly become much riskier in the future.
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