In early 1998 with its stock trading at around twenty dollars, Enron Corporation rapidly became the darling of Wall Street. Having its roots in the 1930s out of the Northern Natural Gas Company and InterNorth, Enron was seen as both a stable, well-managed company in a commodity business and an innovator and disrupter. Company executives were the “smartest guys in the room.” Newly minted Ivy League MBAs were turning down offers from Goldman Sachs and Morgan Stanley to take jobs with the powerhouse in Houston. And the company was printing money.

Fortune magazine hailed Enron as “America’s Most Innovative Company” for six straight years. The once staid and sleepy natural gas company was expanding across the globe like the latest social media app.

By mid-1999, just a year and a half later, the stock had more than doubled and seemed to be heading higher. Was Enron, in August of 1999, a good investment? What about that November? After hitting a new all-time high of $44.00, the stock price retreated to around $35.00, a twenty percent decline. Again, was it a good investment here?

Of course, with the benefit of hindsight, we know it wasn’t. We know Enron was a fraud and that much of its management went to prison, and in the aftermath of this spectacular scandal, the company declared bankruptcy in December 2001.

But the question remains. Was it a good investment in 1999? Well, between November 1999 and August 2000, in just ten months, you would have nearly tripled your money. Isn’t that a good investment? Sure, it was risky, but. . .

Investment risk is an integral part of the investing process. When we invest, taking on risk is how we get paid. But an astute, successful investor is one who assumes appropriate risk in order to maximize returns while minimizing losses.

From this perspective, we could have known, in advance and despite the spectacular increase in its stock price, that Enron was too risky and a bad investment. Not because it eventually went bankrupt but because a good investment policy would advise against ever investing in any single security.

In simplest terms, investment risk is the potential for an investment’s value to fluctuate in response to market conditions, the financial performance of the business, or other factors. Therefore, understanding and managing risk is crucial for investors to make informed decisions and achieve their investment goals.

A crucial distinction, then, is understanding the difference between portfolio and security risks. Portfolio risk, sometimes referred to as market risk, refers to the risk associated with the overall portfolio, which comprises a combination of individual securities. It measures the volatility of the portfolio’s returns and various other objective factors. Security risk, on the other hand, refers to the risks associated with an individual security, such as a stock or bond. It is the risk of loss you face due to factors such as poor financial performance, changes in the industry or economy, changes in the issuer’s creditworthiness, and, of course, scandal and fraud.

For example, let’s say an investor has a portfolio consisting of 50% of their assets in stock A and 50% in stock B. If the overall market experiences a downturn, stock A and stock B may both decrease in value. While most portfolios are made up of more than two stocks, this is an example of portfolio risk. That is, you will experience gains and losses in line with the performance of the market.

However, if stock A is a well-established company with a solid financial track record and stock B is a start-up with a high level of uncertainty. In that case, you are exposed to elevated and significant security risk with stock B.

An important point to keep in mind is that security risk can be eliminated – or reduced to an insignificant level – through diversification. Many academic studies conclude that investors are not even compensated for security risk and since it can be eliminated, this makes sense. The possibility of dramatic returns is more than offset by the security risk, as was the case with Enron.

On the other hand, you can measure portfolio risk. It can be measured and quantified – and therefore controlled. And when combined with the returns on a portfolio, an investor can develop an analysis of the portfolio’s performance and make objective decisions on his investment objectives.

Many investors evaluate their investment choices solely on the basis of investment performance, typically for the last ten years or so. And while it cannot be said enough that “past performance is not an indication of future performance,” the story goes deeper than this undeniable fact as we’ve seen in our example with Enron.

Consider two portfolios – or mutual funds – available to you in your 401(k) plan. Both had identical returns over the preceding one and ten-year periods. So you might reasonably conclude that the funds are identical – a coin flip. But while doing some research, you discover that one of those funds assumed much more risk to achieve those returns.

Which fund should you choose? Well, that is a separate question. Perhaps the fund with the higher risk invests in riskier small-cap or international stocks, and higher returns can be reasonably expected over the long term. On the other hand, the fund with the lower risk may have held too much lower-risk cash or bonds. Because a fund has statistically higher risk doesn’t make it a wrong choice if a higher risk profile is its manager’s objective. Perhaps you should invest in both. Perhaps neither. A good investor knows that risk and return are intimately related and that decisions based on gross returns alone are usually wrong. But he also knows that basing investment decisions on a measure of risk is likewise incorrect.

There are several statistical measures an astute investor can use to quantify portfolio risk. More importantly, they can be used to make intelligent comparisons among various mutual fund portfolios. Finally, and most critically, investors can use these tools to design and build a portfolio aligned with their objectives and risk tolerances.

So what are these statistical measures of risk? In the following paragraphs, we list and define those that are the most frequently used and cited. You’re likely to see them in an analysis of a fund or, sometimes, in the fund’s own literature. Certainly, you will find these stats in a Morningstar, Lipper, or Zacks report.

What we won’t do is explain the intricacies of using these measures to build and manage an investment portfolio, as that is beyond the scope of this article. Instead, we offer a course on our website on this topic and encourage you to check it out if you want to learn more. But here, our goal is to make you aware that these statistical measures exist and, in a limited way, explain what they mean.

Let’s take each, one at a time:

Standard Deviation

We all know what a mean, or average, is. For example, let’s say we calculate the average price of a stock or mutual fund over the last 100 days and do that every day for the previous year. If we compare that average price to the actual price, perhaps on a chart, we’d see a smooth line representing the average price and a more jagged line representing the stock’s actual price. We’d also notice that the actual price was, at times, above the average and sometimes below. Finally, we’d see that the actual price deviated from the average price.

As its name implies, Standard Deviation uses a mathematical process to standardize these calculations across markets and investments so that an investor can meaningfully and objectively compare various investment choices.

Standard Deviation is the most common statistical measure of risk. In our experience, it aligns reasonably well with investors’ psychological perception of risk as well. The higher the standard deviation, the greater the risk. Typically, the stock of a smaller company will have a higher standard deviation than the stock of a larger company. Conversely, an index or mutual fund will have a lower standard deviation than most component stocks.

Standard deviation is backward-looking, and like most things in investing, past results are not an accurate predictor of the future. Many investments, especially stocks, experience wide swings in the standard deviation from year to year and even month to month.

Beta

If Standard deviation is a measure of the variance of an investment when compared to its own average, Beta is a measure of its variance compared to a benchmark or to the market. It is a measure of how correlated the returns of a particular fund are with the market.

For example, you can expect an S&P 500 index fund to have a beta of 1. That is, its returns should – and probably will – very closely match the returns of the S&P 500 index.

Let us consider two mutual funds with similar objectives, for example, two large-cap growth funds. Examining the beta of these two funds can help us decide in which one to invest. Assuming a benchmark of the S&P 500, a fund with a beta of less than one will likely have less risk than the market but will just as likely have lower returns. Conversely, the fund with a beta of greater than one will probably exhibit more risk but greater returns.

Understanding and use of beta can guard against what I call “false diversification.” Often, investors will invest in several funds, believing they have properly diversified, when upon closer analysis, all of those funds will have the same or nearly the same beta with respect to the same benchmark.

For example, a fund that invests in small-cap or international stocks will probably have a low beta with respect to the S&P 500. Perhaps .5 or lower. A fund that invests in commodities might have a negative beta.

Alpha

The Efficient Market Hypothesis, developed in the 1960s by University of Chicago, Noble Prize-winning economist Eugen Fama contends that the prices of a security and investment contain all of the available information on that security or investment. It concludes that it is, therefore, impossible to “beat the market” and that market returns are the best an investor can hope to achieve.

If this is true, Alpha does not exist.

While the subject is exceedingly complex and while there is abundant evidence in support of the EMH, I tend to disagree. There are many examples of investors and fund managers who have consistently outperformed the market over decades and decades. Berkshire Hathaway, which is, of course, a business, not a fund, but which has closely followed CEO Warren Buffet’s investment philosophy for over forty years has dramatically outperformed the market. There are any number of investors who have done likewise. So the topic remains controversial.

And Alpha surely does exist! So what is it?

Alpha is a measure of how much an investment strategy beat the market, or, in other words, its excess return. An alpha of zero would indicate that a mutual fund is tracking the index and the manager has not added any value when compared to the index.

A negative alpha means that the strategy underperformed the market while a positive alpha, the goal of every investor and portfolio manager is an indication that the manager added value and generated returns beyond what the market generated.

The calculation of alpha is dependent on the fund’s benchmark and assigning a fund to a benchmark is often quite subjective. Therefore combining an analysis of beta, which is a measure of a fund’s correlation with its benchmark, and alpha will perhaps yield a greater understanding. A beta of one, or nearly one, and a positive alpha mean that the fund did indeed outperform its benchmark.

A fund with a beta of close to one and a negative alpha probably should be avoided.

It is my view that attempts for the typical, do-it-yourself investor, to generate a positive alpha are probably misplaced. Excellent outcomes can be achieved by keeping expenses very low and by proper and consistent asset allocation. Indeed these strategies probably result, over the long term in a positive alpha.

Other Portfolio Risk Measures

Another critical measure of portfolio risk is the Sharpe Ratio, which measures the risk-adjusted return of a portfolio. It is calculated by dividing the portfolio’s return in excess of the risk-free rate by the standard deviation of the portfolio’s returns. The Treynor Ratio, which is similar to the Sharpe ratio but uses beta as the measure of risk, and the Sortino Ratio, which considers only the downside risk, can also be used to evaluate portfolio risk.

While it is important to understand and manage portfolio risk, investors should also be aware of the risks associated with individual securities. This is where mutual funds can be beneficial. Mutual funds are a type of investment vehicle that pools money from multiple investors to purchase a diversified portfolio of securities. By investing in a mutual fund, investors can reduce security risk by diversifying their investments among a large number of securities.

There are different types of mutual funds, including index funds and actively managed funds, which vary in terms of risk. Index funds, which track a market index, generally have lower risk as they are not actively managed. Actively managed funds, on the other hand, have higher risk as the fund manager is making investment decisions that may or may not be successful.

To evaluate the risk of a mutual fund, investors can use tools such as Morningstar ratings. Morningstar assigns mutual funds a risk rating based on their volatility, which can help investors identify funds that align with their risk tolerance.

In addition to understanding and managing portfolio and security risk, investors should also focus on building a well-diversified portfolio. Diversification is a key principle of investing and can help to reduce portfolio risk by spreading investments across different asset classes and sectors. This can help to reduce the impact of market fluctuations on the overall portfolio.

Asset allocation is another important aspect of managing risk in your portfolio. This involves dividing your investments among different asset classes such as stocks, bonds, and cash. By allocating assets in a strategic manner, investors can balance risk and return and achieve their investment goals.

Another important aspect of managing risk in your portfolio is understanding your risk tolerance. Risk tolerance is the level of risk an individual is willing to take on. Investors need to understand their risk tolerance so that they can make investment decisions that align with their goals and comfort level.

In conclusion, understanding and managing risk is a crucial aspect of investing. It is important for investors to differentiate between portfolio risk and security risk and to use statistical measures to evaluate portfolio risk. Mutual funds can be a valuable tool for reducing security risk, and building a well-diversified portfolio, asset allocation, and understanding your risk tolerance can help to manage risk in your portfolio. As investors, it’s important to understand that past performance should not be the sole factor in investment decision-making and the importance of understanding the underlying risk. Investors must re-evaluate their investment portfolios and consider the role of risk in their investment decisions.