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Dealing With Risk


BusinessWeek Investor: The Framework

Dealing with Risk

As the bull market that has spanned two decades continues into the new millennium, a furious debate is raging. Are investors setting themselves up for a big fall, or are they positioning themselves to profit from an era of unprecedented technological change? However the question is resolved, one thing is clear: Americans are revising their beliefs about financial risk. The traditional view, forged during the Depression, defines risk as exposure to loss. But many investors today seem more concerned about being left behind by a market that has rewritten the rules as it has climbed ever higher. Indeed, a BUSINESS WEEK/Harris Poll conducted in early December indicates that while a majority of Americans think stocks are overvalued, most assume the market will head higher. Still, it's worth noting that more stocks fell than rose in 1999. That is a reminder that it's too soon to declare the old-fashioned definition of risk dead. To give you tools you need for this new era, the articles that follow explain how the definition of risk is shifting and why investors appear more willing to take on risk. We also help you assess whether you've taken on the right amount of risk to meet your goals and how to structure a portfolio to give you the best possible returns for the risk you're comfortable taking.By Anne TergesenReturn 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 & CORDAROReturn to top


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