Dear Dagen: Understanding Risk

It's hard to understand the real risks of Rollerblading until you try it and break your wrist.

And it's hard to understand the real risks of investing until you try it and lose your money.

Measuring Up Minimum Investments: Tips on how to invest if you have only a little money.

10 Questions With Phoenix-Duff & Phelps Real Estate Fund Manager Michael Schatt: Is now a good time to invest in REITs?

Unfortunately, that's been the experience of many mutual fund investors over the last several years. The average large-cap growth fund has fallen 14.8% in the past 12 months. The average technology fund has inflicted even more pain, dropping 28.7% in the same time period.

When the market was soaring, plenty of investors probably didn't recognize how much risk they were taking or how volatile their funds could be. "I've found that a lot of people, when the market was running up in '98 and '99, could sleep just fine because they didn't realize the risk they were taking," says Bryan Olson, vice president of Charles Schwab's Center for Investment Research.

Now that downside is quite palpable. It's probably the first thing you think about before buying a mutual fund.

Thankfully, there are a few simple tests you can perform to gauge just how volatile a fund might be. You'll never know exactly how much money a fund will make or lose in the future. But looking at its past volatility and its portfolio composition can help you decide if you should own it or ignore it.

Measuring a Fund's Swings

When you're buying a fund, the goal is to understand how much risk you're taking on. Theoretically, your potential is greater if you assume more risk. Stocks, for example, will typically return more than bonds over long periods of time.

There isn't one single statistic that's going to tell you everything you need to know about a fund's risks and its potential. But you can start by looking at a fund's standard deviation. This number measures the range of a fund's performance around its average. If a fund's standard deviation is high, its range of performance has been wide. The higher the standard deviation, the greater the volatility.

Volatility isn't necessarily a bad thing: It's the chance that a fund will go up or down a lot. But it's the down that might give you an ulcer.

This statistic, by itself, won't tell you if a fund is dicey. You have to compare one fund's standard deviation with others in its peer group. To learn whether one technology fund is more volatile than another, look at the standard deviations for both. (You can find this stat on Morningstar's Web site.)

If you want to know how volatile a fund is compared to a broader benchmark such as the S&P 500 or the Wilshire 5000, you can compare its standard deviation to that of an index fund that tracks one of those indexes.

But this number alone can be misleading. A fund that has consistently lost money can have a low standard deviation because it has been just that -- consistent.

When to Watch Short-Term Performance

Standard deviation is useful, but you probably need more than just one raw number to grasp a fund's risk. To decide if you can really stomach the swings in a fund's performance, look at its best and worst returns over short and long periods of time: How much did a fund rise in its best year? How much did it fall in its worst? How much was it off during its worst quarter? And how does that compare to the broader market?

Then ask yourself: Can I live through that?

A lot of professionals will tell you that you shouldn't eyeball a fund's short-term performance. But its swings in one day, week or month can give you some idea of how volatile a fund is. If the market falls 1% in a day and a fund you own drops 5%, that tells you at least something about the risk a manager is taking.

When you're analyzing a fund, you can also inspect its sector allocation and its concentration in the fund's top 10 holdings, comparing it with a similar fund or broad benchmark. "If more than a third of a fund's assts are in its top 10 holdings, those are some pretty heavy bets on individual stocks," says Olson. "Again, it's not always bad, but you need to be aware of it because it's a potential risk."

Look, for instance, at the (JAVLX Quote)Janus Twenty fund, a concentrated growth fund that once bet big on tech, media and telecom stocks. It lost 24.6% in the first quarter of 2001, while the (VFINX Quote)Vanguard 500 Index fund only fell 11.9%. That says something about its volatility. (Janus Twenty is closed to new investors, although investors probably aren't desperate to get in at the moment, given its 23.7% loss in the past year.)

If you can't stand the fluctuations in the funds you own, you can always fall back on that basic tenet of investing: diversification. You want to have your money in securities and asset classes that don't all move in lockstep with one another. Bonds and stocks don't typically move in tandem. And the swings in a portfolio that holds both stocks and bonds will be less dramatic.

Looking at the past 76 years ending Dec. 31, a portfolio that was entirely invested in the S&P 500 lost 43.1% in its worst year and suffered 22 losing years. A portfolio with 60% in that index and 40% in corporate bonds fell 26.6% in its worst year and had a loss in 19 of those 76 years, according to data from Vanguard.

The average annual return of the all-stock portfolio: 10.7%. But with 40% in bonds, the portfolio still returned an average of 9.1% a year. For some investors, that extra return might be worth the risk. For others, it isn't worth the stress.

To figure out the best allocation for your needs, Charles Schwab's Web site has an asset allocation tool that includes five model portfolios, ranging from aggressive to conservative. The site also includes the returns of these portfolios over a 31-year period.

Nevertheless, gauging the amount of risk you can bear is incredibly difficult. The risk of different investments and your own risk tolerance will change over time. "The good news is, if you've been invested over the last five years, you've seen the extremes of risk -- the highs of '97, '98 and '99 and the lows of 2000 and 2001." says Olson. "You've got the real-life experience of what risk is all about."