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BusinessWeek: January 17, 2000 |
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BusinessWeek Investor: The Framework
Dealing with Risk Return to top  TABLE Risk Terms BETA Beta relates the volatility of a security to that of the market as a whole. If an investment moved exactly as the market moved, it would have a beta of 1.0. ALPHA Most commonly used with mutual funds, alpha describes the difference between a fund's actual return and its expected return, given the level of risk it takes, as measured by beta. A fund with a positive alpha has done better than expected, while a fund with a negative alpha has underperformed. STANDARD DEVIATION A statistical measure of the range a fund's price fluctuates within over time compared with its average price. If two funds have the same average return, investors should prefer the one with the lower standard deviation. To calculate it, average your investment's monthly returns over the past 36 months or longer. Then, subtract this average from each of the individual monthly return figures. This tells you how the investment has deviated from its average return. Then, square each figure and sum the results. The square root of this final number is the standard deviation.* SHARPE RATIO This provides you with a return-per-unit-of-risk measure. To calculate it, take an investment's return minus the "risk-free" rate, divided by the investment's standard deviation. R-SQUARED Tells you the degree to which an investment's returns rise and fall at the same time as the benchmark it is being compared with. An R-squared of 0 means an investment's returns have no correlation with the benchmark's fluctuations. A 100 reading indicates that they are perfectly matched. Low R-squareds also indicate that the beta of the security is not reliable. MORNINGSTAR RISK Measures a fund's downside volatility relative to that of the average U.S. equity fund. To calculate it, Morningstar adds up the amounts by which a fund fell short of the three-month Treasury bill's return and divides by the total number of months in the rating period. DATA: S&P PERSONALWEALTH.COM, BUSINESS WEEK, MORNINGSTAR, VANGUARD GROUP, CBS MARKETWATCH, *BUGEN, STUART KORN & CORDARO Return to top | |
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Is Your Comfort Level Too High? These days, when day traders can make thousands just by riding a hot Net stock for minutes, it seems as if everyone is rolling the dice and coming up a winner. Investors are so accustomed to double-digit stock gains that many are depleting their savings in the expectation of never-ending high returns. And, enticed by stock-option packages once reserved for corporate elites, droves of workers are hitting pay dirt by leaving established companies for unproven startups. Whether this 18-year bull market is headed for disaster or turns out to be evidence of a golden new economic age, the view forged during the Great Depression of stocks as highly risky investments has been upended. "People have come to think of U.S. stocks as the riskless asset," says Brian Singer, managing director of specialized investments and risk analysis at Brinson Partners, a Chicago-based unit of Swiss bank UBS. "People are taking more risks, though they probably don't think they are." Indeed, emboldened by the soaring market as well as academic research suggesting that stocks are less risky than bonds if held for more than 30 years, investors have increased their exposure to this asset class. Today, stocks and stock mutual funds held outside of 401(k) and pension accounts make up a record 39% of household financial assets, up from 11.6% in 1982, the year the bull market was born, says the Ned Davis Research Group. CONFIDENT. So strong is the current appetite for stocks that households are taking on record levels of debt to buy them. Since March, 1997, New York Stock Exchange member firms have doubled their borrowings to buy stocks for clients "on margin"--an arrangement that allows investors to use loans to pay for up to 50% of a stock's price. Although margin debt has remained flat as a percentage of the stock market's rising value, it now equals a record 2% of gross domestic product, up from 1% in 1995, says Jane D'Arista, director of programs for Financial Markets Center, a nonprofit research group in Philomont, Va. "People feel they have to rush to take advantage of this market," she says. "But I'm not sure many understand the risk, because they have yet to live through a margin call"--a repayment demand triggered by sliding share prices. Investors' high expectations could set them up for a fall. With the Standard & Poor's 500-stock index coming off of five consecutive years of double-digit gains, the 1,010 people PaineWebber polled in early December expect average annual stock returns of 19% over the next 10 years--far above the long-term average of 10%. Moreover, though surveys--including a recent BUSINESS WEEK/Harris Poll--indicate that most people think the market is overvalued, they seem little concerned that it will ever suffer a lengthy losing streak. When Robert Shiller, a Yale University economics professor, asked 147 people in 1999 whether the market would recover within a couple of years from a crash similar to the one in 1987, an overwhelming 91% said it was somewhat or very likely to rebound, up from 82% in 1996. "People think the market has short-run risk but that if you ride it out, there is no risk," Shiller says. Perhaps for that reason, investors have stayed with stocks even as overall volatility has increased. According to the widely followed CBOE Volatility, or VIX, Index--which measures price changes on options to buy or sell S&P 100-stock index contracts--volatility is nowhere near where it was in the midst of Asia's financial crisis in 1998. However, it is about 50% above its 1995 level. With rich stock valuations also doing little to dampen demand, Federal Reserve Chairman Alan Greenspan wondered aloud in a speech on Oct. 14 whether investors are too lighthearted in their attitude toward risk. "History tells us that sharp reversals in confidence occur abruptly, most often with little advance notice," he warned. Of course, over the past two decades, most Americans have had no choice but to become more risk-tolerant. Even as the fall of the Berlin wall eliminated the cold war's military threat, Corporate America was rescinding its tacit promise of lifetime employment. Now, instead of relying on corporate paternalism, employees assume the risk of managing their retirement portfolios as well as their careers. When it comes to investing, developments unique to the current bull market also promote risk-taking. Consider the rise of online trading, which accounted for 30% of the volume of retail transactions in the first half of 1999, according to U.S. Bancorp Piper Jaffray. On the Internet, average investors can take charge of their own trading and get financial data previously available only to pros. The downside, though, is that this often fosters a false sense of confidence that prompts traders to engage in more speculative transactions online than off. "Individual investors don't do that well with speculative trades. On average, the stocks they buy underperform those they sell," says University of California at Davis finance professor Terrance Odean, co-author of a recent study on online investing. "That says to me that they are underestimating their risk." Still, the most likely explanation for people's rising comfort with financial risk is the safety net created by years of prosperity. Richard Thaler, a University of Chicago Graduate School of Business economics professor, has found that like gamblers, investors tend to take more risks when they feel they are ahead of the game. In experiments, Thaler gave some people $30 and others nothing. Those with a nest egg to fall back on were more likely to gamble when offered the chance to flip a coin for $9. These findings indicate that appetites for risk expand and contract along with the Dow Jones industrial average and the S&P 500. However, as memories of the Depression fade and the economy enters an era of technology-driven change, even Greenspan argues that at least part of the recent decline in risk aversion should be permanent. "The rise in the availability of real-time information has reduced uncertainties," Greenspan said in his Oct. 14 speech. LITTLE PROTECTION. In what they believe to be a reduced-risk environment, investors are willing to pay more for stocks. But rich stock prices also create a catch-22: As valuations soar, so can volatility--a key measure of risk, notes Edward Keon, quantitative research director at Prudential Securities. By most measures, volatility has risen since the early days of the bull market. "When price-earnings ratios are high, it means investors are very confident the future is going to be good," Keon says. This increases risk because it leaves little protection against bad news--as Tandy Corp. shareholders discovered on Dec. 17 when the stock lost 20% of its value on news that holiday sales were weaker than expected. Even Jeremy Siegel, the Wharton School professor who popularized the notion that stocks are less risky than bonds if held for long periods, cautions that some of the confidence his work has inspired may be misplaced. In a bear market, he says, investors could easily panic and abandon long-term commitments to stocks, exposing themselves to more risk than they had bargained for. "History tells us," he warns, "that very recent performance burns in our minds much more strongly than some academic study that says that if you hold on you will be all right." Return to top  Return to top  Return to top How Much Volatility Can Cost You Even if you swear you will cling to your stocks through a ferocious bear market, it doesn't pay to ignore risk. For one thing, investors who match their risk tolerance to the risk in their portfolios have a better chance of sticking to their plans when things get ugly. Risk also has a big impact on what investors care most about--returns. Generally, as an investment's riskiness rises, so does the potential for a big payoff. But because high-octane securities are prone to blow-ups, it's foolish to assume that the road to riches is paved with Internet stock certificates. To see why, throw a dart at the 10 riskiest mutual funds ranked according to a common measure called standard deviation. You might find a winner, like the Internet Fund, which returned an average of 89.2% annually over the past three years. But you might also draw the Lexington Troika Russia Fund, which lost an average of 20.6% a year over the same period. Of course, when picking stocks and funds, most investors search for hot performers. This doesn't work either. But because an investment's risk level tends to remain constant over time, risk-adjusted returns have "some predictive value," says Leah Modigliani, a Morgan Stanley Dean Witter U.S. investment strategist. In a study that ranked 660 stock mutual funds with 10-year track records according to risk-adjusted returns, Modigliani found that a statistically significant 39% of those in the top quartile during one five-year period landed there again in the next five years. Morningstar, BUSINESS WEEK, and S&P Personal Wealth also offer risk-adjusted rankings of thousands of mutual funds. BIG DIFFERENCE. The value of risk-adjusted returns is clear when you compare two investments, each earning an average of 10% a year. Because of compounding, $100,000 invested in a portfolio that rises a steady 10% each year will become $672,750 after 20 years. That same $100,000 is worth only $480,000 after two decades if it is invested in a more volatile fund that alternates between 30% annual increases and 10% annual declines, according to Bugen Stuart Korn & Cordaro, a Chatham (N.J.) money-management firm. Before gauging the riskiness of your investments, it's important to understand your tolerance for financial uncertainty. Time horizons play a big role, with those needing cash soon able to take fewer chances than those who don't. To assess a client's comfort with risk, Bugen Stuart demonstrates what would have happened to an investor who put everything in stocks in 1973 and 1974, when the Standard & Poor's 500-stock index lost about 40% of its value. If clients lack the nerve or cash to hang tough, the firm reduces its recommended commitment to stocks until hitting a comfort zone. "The worst thing I can do is put you in a portfolio that is too volatile and have you bail out at the bottom," partner Christopher Cordaro says. Indeed, in 1975, the S&P 500 rose 37.2%. Whether big swings in stock prices thrill or scare you, keep in mind that when constructing a portfolio, risk is only one factor to consider. Another is how much your investments need to earn to meet your goals. If you're too conservative, you might unwittingly expose yourself to an even greater risk than that posed by the stock market--that of not having enough money to retire on. Return to top The Nitty-Gritty: How to Do the Math How can you figure out how much downside risk an investment exposes you to? Answering this critical question can be tricky: There are so many ways to calculate risk. On top of that, many risk measures have their own limitations. And then there's the separate question of how you should use the risk barometers you pick. But there is one rule you should always follow. Although it is easy to get a separate risk reading on each of your investments, you should care only about how your portfolio rates as a whole. It's important to go for the big picture because a diversified portfolio carries less risk than the sum of its parts. The reason is that in a diversified portfolio, individual components--such as stocks and bonds--are unlikely to move in sync, especially over the long term. Thus, each can offset some of another's risk. The volatility of stocks, for instance, could be balanced out by the fixed interest and principal payments of bonds. LOTS OF BASKETS. It's hard to grab a calculator and arrive at a figure that reflects the overall risk in a portfolio. Still, a back-of-the-envelope reckoning provides a rough--though inflated--gauge, says Judith Ward, a certified financial planner at T. Rowe Price Associates Inc. in Baltimore. Just research the risk scores discussed below on each investment and multiply by their percentage weightings in your portfolio. Then, calculate an average. "It's not ideal," says Ward, who notes that this fails to account for diversification's risk-reducing magic. "If you are diversified, your risk is probably going to be less." For something more accurate, you can hire a financial adviser. Or you can use a free Web service such as Financialengines.com to assess how risky your portfolio is, compared with that of the average investor. To define risk, Financialengines uses the measure known as standard deviation, which it expresses as a numerical score. For instance, if your rating is 1.4, then you are taking 40% more risk than the average of 1.0. Whatever approach you take, the results will be easier to interpret if you have a grasp of how professionals measure financial risk. When it comes to stocks, investors confront two types of risk. One is posed by market downdrafts, which can punish even the most worthy investments. The other consists of problems specific to companies, such as mismanagement or obsolete products. For mutual funds, there is a third variety of risk, which is posed by "a bad manager who charges high fees and doesn't make enough to recoup that cost," says Martin Gruber, finance professor at New York University's Stern School of Business. TOO CRUDE? Happily, about 96% of company-specific risk can be eliminated simply by owning a diversified portfolio of 40 to 50 stocks, Gruber says. The risk that remains--a loss due to a market sell-off--is captured in a measure called beta. Beta compares the magnitude of an investment's price swings with the market's overall fluctuations. To see how it works, look at the Internet Fund. With a beta of 2.24, it is deemed more than twice as risky or volatile as the market, which is always assigned a beta of 1.0. So, if the market drops by 10%, the fund should fall by 22.4%. Fidelity Magellan Fund, in contrast, nearly matches the Standard & Poor's 500-stock index: Fidelity is 1.02. Appealing because of its simplicity, beta is sometimes too crude to be useful. For one thing, it is often calculated compared to the S&P 500, a big-cap measure that is a poor yardstick for other asset classes. To find out whether you can trust beta to give you an accurate picture of an investment's risk, look up another statistical measure, R-squared. This tells you the degree to which an investment's price rises and falls at the same time as the benchmark it is being compared to. An investment's beta can be considered reliable only if its R-squared falls between 85 and 100, meaning that it closely tracks the index. Thus, the Vanguard Gold & Precious Metals Fund's R-squared of 0.08 compared with the S&P signals its beta of 0.70 is a poor measure of the fund's true riskiness. When confronted with a low R-squared, find a beta based on a better benchmark. For mutual funds, Morningstar.com publishes betas that use both the S&P and the most appropriate index. For stocks, Personalwealth.com tailors betas to peer groups, such as computer hardware stocks. But be wary of beta when a company or fund specializes in fast-changing technologies. "The beta is also going to change rapidly," Gruber says. Of course, if your holdings are not diversified, it can be dangerous to rely on beta at all. Gruber notes that when it comes to individual stocks, beta explains only 35% of the risk. The rest is due to company-specific developments. GO FIGURE. For an all-inclusive picture, look at standard deviation, which compares the range an investment's price fluctuates over time to its average price. A fund with a standard deviation of 4 and average annual gains of 24% over the past three years can be expected to deliver returns that fall within four percentage points of its average two-thirds of the time. In other words, you can generally expect to see gains that range between 20% and 28%. It's possible to calculate standard deviation yourself (table, page 103). But Microsoft Corp.'s Excel program has a standard- deviation calculator that makes the task easier. Still, standard deviation has flaws, foremost of which is that it is often calculated using 36 months of returns. As the market's hot gains over the past three years indicate, short time horizons may not be representative of the long run, says Ken Fuller, vice-president at T. Rowe Price. To avoid this problem, Morningstar provides standard deviations of 3, 5, and 10 years. Standard deviation is also often faulted for penalizing funds that soar just as much as those that plummet. Of course, most investors complain only when they lose money. In part to respond to this criticism, Morningstar came up with "Morningstar Risk," which ranks funds by how often they underperform the returns of three-month Treasury bills, a nearly risk-free asset. The higher the score, the riskier the fund. Take the Oberweis Emerging Growth fund. Its five-year rating of 2.32 means that the fund has 132% more downside risk than the typical U.S. stock fund, which is assigned a value of 1.0. Such volatility is also reflected in the fund's annual returns, which range from a loss of 8.55% in 1997 to a gain of 87.06% in 1991. A shortcoming of the Morningstar system is that it can be used only to compare similar funds. For example, while a bond fund with a score of 1.3 is 30% riskier than the average bond fund, there's no way to tell if it is less risky than a stock fund with a score of 1.0. Three other commonly used risk measures gauge risk-adjusted performance. The most well-known, the Sharpe ratio, is the brainchild of Nobel laureate William Sharpe, a Stanford University professor and the chairman of Financial Engines Investment Advisors. Sharpe's formula measures the extra return investors receive for each unit of risk they take. The beauty of the Sharpe Ratio is that it allows for an apples-to-apples comparison of different assets. "If the Sharpe ratio is higher for one fund than another, I am getting a little more expected return for taking that expected risk," Gruber says. That is certainly true of Legg Mason Value Trust, which returns 1.09 for each unit of risk, compared with 0.55 for the average U.S. stock fund, according to Morningstar. A similar result is furnished by M-squared, the creation of Leah Modigliani, a U.S. stock strategist at Morgan Stanley Dean Witter, and her grandfather, Nobelist Franco Modigliani. M-squared adjusts an investment's risk level to match that of a benchmark, such as the S&P 500. How? To reduce the standard deviation of a volatile technology fund, for example, the Modiglianis' computer adds risk-free Treasury bills to the portfolio until it matches the S&P 500. For a conservative fund, they use leverage--or borrowed funds--to simulate more exposure to stocks. When adjusted for risk, some top performers look decidedly less attractive (table). Take the Internet Fund. Over the past three years, it has returned an average of 89.2% annually. But on a risk-adjusted basis, its performance falls to 28.2%, says Leah Modigliani. Although you can crunch the numbers yourself, it's easier to ask your fund manager or investment adviser for figures. HOLY GRAIL? Another way to determine how well a fund or stock stacks up is to look at its alpha. Alpha measures whether an investment is producing better or worse results than expected, given its risk. Consider a fund with a beta of 0.5. If the market rises by 20%, it would be expected to gain half as much, or 10%. If the fund instead increases by 15%, its alpha is 5, meaning it beat expectations by five percentage points. Although many consider low betas and high alphas the Holy Grail of investing, both measures are subject to the same distortions. Like beta, alpha reveals little unless a fund closely resembles its benchmark. Plus, high alphas do not predict future performance, says Thomas Schneeweis, finance professor at the University of Massachusetts at Amherst. Indeed, when it comes to forecasting, very low alphas are more valuable: They sometimes signal poor performance ahead because as investors yank money from lagging funds, it's that much harder for the managers to keep up, Schneeweis says. Understanding risk will help you build a better portfolio, but getting a handle on risk doesn't eliminate it. If the market falls 10% and your fund is down 8%, you might feel a little smarter than your neighbor. But you have still lost money. The trick is to use the tools that are now so widely available to minimize damage during downturns and make sure your long-term goals jibe with the risk you are comfortable taking. Return to top TABLE Where to Find Risk Measures for Funds WEB SITE (www.) and WHAT'S AVAILABLE businessweek.com/investor/ Proprietary risk-adjusted ratings on nearly 4,000 stock and bond funds cbsmarketwatch.com Standard deviation, R-squared, beta, best- and worst-three-month returns morningstar.com Standard deviation, R-squared, beta, alpha, Sharpe Ratio, Morningstar Risk personalwealth.com Standard deviation, R-squared, beta, alpha, Sharpe Ratio Return to top TABLE Returns and Risk for 1999's Top 10 Mutual Funds FUND NAME* 1999 3-YEAR M-** STANDARD
RETURN ANN. RET. SQUARED DEVIATION**
VAN WAGONER EMERGING GROWTH 268.8% 41.2% 20.2% 66.5
WARBURG PINCUS ADV. JAPAN SMALL 263.9 43.8 24.3 50.0
AMERINDO TECH. D 234.2 58.2 23.0 94.4
FIDELITY JAPAN SMALL 210.0 40.0 22.3 50.6
WARBURG PINCUS ADV. JAPAN GROWTH 206.3 43.7 26.3 44.1
PBHG TECH. & COMM. 196.3 45.2 24.4 53.1
VAN WAGONER MICRO-CAP 189.1 37.4 20.0 56.8
INTERNET 184.9 89.2 28.2 129.6
FIRST AMERICAN TECH. A 175.5 48.2 25.2 55.8
FIRSTHAND TECH. VALUE 165.2 44.4 23.6 55.4
FUND NAME* BETA** ALPHA** SHARPE M'STAR
RATIO RISK**
VAN WAGONER EMERGING GROWTH 1.39 14.3 0.60 2.16
WARBURG PINCUS ADV. JAPAN SMALL 0.38 34.7 0.86 1.14
AMERINDO TECH. D 1.77 24.4 0.62 2.42
FIDELITY JAPAN SMALL 0.58 27.0 0.77 1.32
WARBURG PINCUS ADV. JAPAN GROWTH 0.50 30.3 0.97 0.94
PBHG TECH. & COMM. 1.47 12.5 0.84 1.73
VAN WAGONER MICRO-CAP 1.22 12.7 0.63 2.09
INTERNET 2.24 41.4 0.71 2.24
FIRST AMERICAN TECH. A 1.55 13.8 0.86 1.66
FIRSTHAND TECH. VALUE 1.58 10.4 0.79 1.80
*Funds with at least three years of history
**Measured over three years
DATA: MORNINGSTAR; M-SQUARED PROVIDED BY MORGAN STANLEY DEAN WITTER
(RISK MEASURES AND THREE-YEAR RETURNS CALCULATED AS OF 11/30/99; YEAR-TO-DATE
RETURNS AS OF 12/20/99)
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