In some other articles we discuss the impact that risk can have not only on your ability to invest with a system, but highlighted the fact that the risk of the portfolio can have more impact on the sustainable withdrawal rate than the actual average rate of return.

So how do you do a better job of managing the risk of your mutual fund investments? Clearly, for anyone who was investing in the 2000-2002 bear market or again in 2008, you know that it is a sickening feeling to watch the value of your investments just continue to erode over a period of months or years.

To help you manage those risks while increasing your wealth, we are starting a series of articles on managing your investment portfolio risks.

First things first. In order to improve something, we first need a way to measure it. So, how do we plan to measure risk?

Measuring Mutual Fund Portfolio Risk

In the Cooley study we looked at in another article, the risk measure they used was the standard deviation of the annual returns. This is a fairly common measure, if your aren’t familiar with the term standard deviation, it’s simply a measure of how much variation around an average value you will see. Larger numbers are worse for standard deviations. A rough rule of thumb is that about 2/3 of the time the annual return should be within one standard deviation of the average value. For example, if you had an average return of 10%, with a standard deviation of 15%, then about 2/3 of the time the annual return would be between -5 and +25%.

For the sake of simplicity, we will often be measuring investment risk as maximum drawdown, simply the lowest value the total investment portfolio falls to after a peak value. For example, if your mutual fund portfolio grew to be $50,000, and then went back down to $20,000, (a decrease of 30,000) and eventually went back up in value, even exceeding $50,000, the maximum drawdown would be 60% (30,000/50,000). Note that it can’t exceed 100%, since at that point you are completely wiped out.

Sharpe Ratio

There are other ways to measure investment risk, the most popular is the Sharpe ratio. This is favored by Morningstar (if you look at a fund, you can see the risk measures tab, and sharpe ratio is listed among them.) Also using it is the Hulbert Financial Digest rating service. Hulbert uses the sharpe ratio for their ranking of newsletter performance on a “risk adjusted” basis.

The Sharpe ratio uses the standard deviation number we refered to above, but also factors in the return of the investment (actually it factors in the amount of return you get above some “risk free” return like a money market fund.) (The name Sharpe ratio is taken from its inventor William Sharpe, a professor at Standford University). For reference, a higher Sharpe ratio is better.

Unfortunately, there is not a universally accepted way of calculating Sharpe ratio, so for example the numbers from Morningstar and Hulbert cannot be compared directly. More information on Sharpe ratio can be found at http://en.wikipedia.org/wiki/Sharpe_ratio

My personal favorite portfolio risk measure is the Ulcer Performance Index, but the process of calculating it is a little geeky, so we’ll save that for another day. It has the advantage of not penalizing upward volatility (i.e. upside surprises) and it also weights large drawdowns with significantly more weight, which mirrors the angst we feel when we get a large drawdown in our portfolios.

A great little tutorial on risk metrics can be found at
http://www.tangotools.com/ui/ui.htm

In some related articles we will be looking at 3 different ways of controlling portfolio risk, and simple ways you can implement them in your own investment portfolio.