|
|
|
|
Bull Market Or Bear Market, Measure Your Exposure To Loss
t is difficult to imagine actually losing money in this bull market, looking at the latest quarterly performance figures for mutual funds, as well as the Dow Jones Industrial Average reaching 9,000. But rest assured losses do happen and they will continue to happen. This article will address three measures of downside risk, which every investor must understand.
First, the good news. For the 1st Quarter, 1998, the bull market marched on. According to the Wall Street Journal, growth funds rose 12.83%. Even the more conservative utility funds rose 10.20%. Worldwide, the gains were even more impressive. European Region funds rose 20.08%. Even the troubled Pacific Region managed to return 3.11%. Perhaps most impressive, no category of mutual fund actually lost money. The worst performance occurred with intermediate term municipal debt, which returned 82%.
Of course, one quarter does not make a year; and a year does not make 3 years, 5 years or 10 years. But investors truly are bombarded with good news, so much so, it would appear, that they forget that the markets are a place to lose, as well as to make, money.
At this point in history, perhaps there is no one in the free world who has not heard of a mutual fund. Among those, a great percentage also know that various magazines, newspapers and other publications rate and rank the performance of mutual funds as frequently as once every quarter. If that fact is unknown, certainly the mutual fund companies themselves do as much as their advertising budgets will allow to promote their performance.
Despite the familiar warning, "Past performance cannot guarantee future results", investors are drawn to past performance when deciding which funds to purchase.
In evaluating mutual funds, investment advisors undertake (or should undertake) a detailed analysis involving many historical, statistical and qualitative factors. Though ordinary investors seldom have the ability, time or interest in undertaking this kind of detailed analysis, there are three measures of downside risk considering.
Standard deviation is the first measure. This is a statistical measure of the range of the mutual fund's performance. Funds with higher standard deviations tend to be more volatile. By definition, approximately 68% of the time, the total returns of any given fund are expected to differ from its mean total return by no more than plus or minus the standard deviation figure. 95% of the time, one can expect the total return to be within a range of plus or minus two times the standard deviation from its mean total return.
For example, two funds can have the same average return of 5%, but with different standard deviations. Let's say the first fund has a standard deviation of 2. That means that 95% of the time, the fund's returns have fallen within the range of 1% to 9%. Another fund has a standard deviation of 4. There is a 95% certainty that this fund will return a range of -3% to 13%. This fact especially is worth knowing if an investor cannot afford to lose any money.
The second measure is beta. How has a fund performed relative to its benchmark? Beta answers that question. The key to beta is to select the right benchmark. For example, mutual funds investing in larger growth stocks should be measured against the S&P 500, and not the Russell 2000. Inaccurate benchmarking will eliminate all value that beta has as a measure of risk.
A benchmark index always has a beta of 1.00. Mutual funds may have betas greater than 1.00 or lesser than 1.00. Betas greater than 1.00 are not always desired. Assume that a large cap growth fund has a beta of 1.50. That means that when the S&P 500 moves up 50 points, the particular fund moves up 1 1/2 times more. That's good news. But in a down market, investors need to know that the same fund will lose money 1 1/2 times greater than the S&P 500.
Finally, consider alpha. When measured properly, and based upon an accurate beta, alpha is a valuable measure. Alpha tells us whether we are experiencing returns sufficient to justify the risk that we are assuming to obtain those returns. Put another way, alpha measures the difference between a fund's actual returns and expected performance, given its level of risk, as measured by beta.
So, a positive alpha figure indicates that a fund has performed better than its beta would have predicted. This also is a sign that the money manager is earning his generous pay. On the other hand, a negative alpha suggests underperformance in view of the risk assumed. Perhaps a money manager change is in order.
These three measures of risk are important for every investor to consider before investing in a fund based upon it past performance, no matter how impressive.
|
Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
All content Copyright © 2010 Advocate Compliance Partners, Inc. except where noted. All rights reserved.
One North Franklin Street, Suite 2620, Chicago, IL 60606
Telephone 312-332-0000 | Fax 312-332-0003
|
|
|
|
|
