(MONEY Magazine) – After 10 years of near 20% annualized gains in stocks, we're all feeling pretty smug about our investing prowess. O-o-o-o, we're s-o-o-o smart. As for risk...ha! That's for wusses. Real investors scan the horizon for opportunities, not pitfalls.

Despite our delusions of omnipotence, however, one day the market will inevitably reverse course--and smack us upside the head with losses. There's not a whole lot you can do about that, except for one thing: You can run your portfolio by a variety of risk indicators to see how it might behave when the days of reckoning come--and perhaps you can fine-tune your holdings ahead of time.

This column explains three risk indicators I believe all investors should be on a first-name basis with. You'll no doubt notice that all three are based on past performance, which leads to a sensible query: "Hey, can these measures tell us anything about the future?" Fortunately, the answer is a qualified yes. "If an investment has been volatile in the past, it will likely be volatile in the future," says New York University finance professor Martin J. Gruber. I don't have to tell you, of course, that the prof is not making any guarantees. We're talking probabilities here, not certainties. And if a fund changes its investment style--starts buying large-cap stocks instead of small ones, say--then all bets are obviously off.

With that warning in mind, here's a rundown of my three favorite risk measures.

Beta: Originated in the early 1960s by Nobel laureate economist William Sharpe, beta tells you how much an investment's returns go up and down in relation to a specific benchmark. Beta is typically used to monitor the volatility of stocks and stock funds, and the benchmark of choice is Standard & Poor's 500 index. I won't burden you with the minutia of how it's calculated. Suffice it to say that whichever benchmark you use is assigned a beta of 1; investments with betas higher than 1 fluctuate more than the benchmark, while those with lower betas fluctuate less. If the S&P 500 gained 10%, you'd expect a stock fund with a beta of 1.2 to rise 12%. If the S&P 500 lost 10%, the stock fund should fall 12%. Nifty, huh?

Before you get too thrilled about beta, though, you should know about one of its shortcomings: It works better for portfolios of stocks than it does for individual issues. "While beta explains about 90% to 95% of the volatility of a diversified portfolio of stocks, it explains only 30% to 35% of the volatility of an individual stock," says Gruber. That's because beta captures only movements triggered by underlying market forces, not those caused by other factors, such as inept management, industrywide slumps, and the like. These nonmarket factors tend to cancel each other out in a diversified group of stocks.

Standard deviation: This seemingly oxymoronic concept (Can something be standard and a deviation?) measures volatility regardless of what drives it--the market, interest rates, sinister outside forces, whatever. Conceived in the early 1700s by Abraham de Moivre, a probability pioneer and contemporary of Isaac Newton (the gravity guy), standard deviation tells you how much the short-term returns of a security or portfolio of investments have jumped up and down around its long-term average--and are therefore likely to do so in the future. It can be calculated in a variety of ways, but the most common method today is to figure the deviation from an average monthly return over a three-, five- or 10-year period and then annualize that number. Mathematical gobbledygook aside, the bigger an investment's standard deviation, the more volatile that investment has been and will probably be in the future. (For a detailed look at how standard deviation works, see the chart on page 73.)

The real beauty of this measure is its flexibility. Using standard deviation, you can compare the volatility of two different types of securities--stocks vs. bonds, for example--or you can apply this yardstick to similar investments. Take the Oberweis Emerging Growth and Fasciano small-growth funds. Both posted comparable annualized gains for the 10 years through July 31--13.7% and 13.3% respectively. But Oberweis had a standard deviation of 32.1% vs. 14.6% for Fasciano. So while both funds took their shareholders to similar places, Fasciano offered a much smoother ride.

Downside risk: Standard deviation treats upward and downward variations equally. But have you ever heard anyone complain, "This fund's returns are too high. The volatility is killing me!" No. Most of us worry about losing money. That's why Morningstar created a gauge for mutual funds called Morningstar risk, or downside risk. To come up with this stat, Morningstar analysts first measure the extent to which a fund has earned less than risk-free Treasury bills on a monthly basis over the past three, five and 10 years. They then calculate a risk score for each fund based on how its record vs. T-bills compares with the average for its peers. A score of 1.2 means the fund has 20% more downside risk than its peers--that is, the average amount by which it underperformed T-bills was 20% higher than for similar funds--while a score of 0.9 shows a fund has 10% less downside risk.

Though helpful, this measure can be used only to compare similar funds--bond funds vs. other bond funds. For example, a bond fund with a score of 1.1 is 10% riskier than the average bond fund. But since bonds aren't nearly as volatile as stocks, a bond fund with a score of 1.1 will be much less risky than a stock fund with a 1.0 score.

Before you run off to see how your investments stack up on these indicators, I've got two caveats. First, while it makes sense to check out the risk of individual securities, it's more important to monitor the volatility of your portfolio overall. Standard deviation is the best way to do that. But calculating standard deviation for a portfolio of investments is tricky. Many financial planners have software for this sort of heavy-duty number crunching, and Morningstar's Principia software will calculate the standard deviation of portfolios of funds.

Another alternative: Go to the free Financial Engines calculator (developed by beta man William Sharpe) at www.money.com/contents or visit www.financialengines.com. You won't get a standard deviation. But if you plug in your holdings, plus how much you'd like your nest egg to be worth when you retire, the calculator will do two things: It will tell you how risky your portfolio is compared with the holdings of investors overall and estimate the odds of your portfolio hitting the target you've set.

Finally, while these risk measures are useful gauges for building a portfolio, don't fall into the trap of sacrificing long-term gains to avoid short-term risks. Sticking all your retirement savings in T-bills, for example, may guarantee you a low standard deviation. But this move virtually guarantees puny returns and increases the risk that you may have to shelve your dreams of a lavish retirement with no money worries. In other words, sometimes the biggest risk of all is trying to play it too safe.

Senior editor Walter Updegrave is the author of Investing for the Financially Challenged (Warner Books). You can reach him at investing101@moneymail.com.