When I'm trying to choose a fund, I try to look at its standard deviation
and beta (among other things). How much weight should one really attach to
these measures of risk, and which one should I use?
If the real risk in investing were how much an investment fluctuates, then
you'd be wise to attach lots of weight to measures like these.
Unfortunately, that's not what risk is.
In the end, risk is not how your investments behave, but how you
behave--and measures like standard deviation and beta stand no more chance
of predicting that kind of risk than Donald Trump has of winning the
Husband of the Year Award from the American Matrimonial Association.
There are two forms of risk that really matter. One is whether you
understand a given investment as well as you think you do. The other is
whether you've correctly anticipated how you'll react if your analysis
turns out to be wrong.
Here's an example of the first kind. At the end of 1993, Piper Jaffray
Institutional Government Income had beaten 99% of its peers for the
trailing one, three and five years. Piper's beta of 0.98% was identical to
Vanguard's Total Bond Market fund, and its standard deviation of 3.93 was
only a tad higher than Vanguard's 3.27. The fund had provided such a
smooth, giant return for so long that its shareholders had come to think of
it as a CD on steroids that went up 10% to 16% a year no matter what bond
But the Piper fund was full of arcane mortgage derivatives like inverse
superfloaters, Z bonds and inverse interest-only planned amortization class
bonds. When the Fed suddenly hiked interest rates in February, 1994, these
derivatives exploded, blowing the fund and its investors to bits. By
year-end, the Piper fund--with its rock-bottom beta, its low standard
deviation, its five- star Morningstar rating and its top Lipper
ranking--had lost 28% of its value.
So much for the predictive power of standard deviation or beta.
It was also a mortifying lesson for the mutual funds editor at Forbes, who
written a glowing article about the fund in that magazine's Jan. 17, 1994
issue. I was that editor, and this disaster taught me that the real risk
was not in the fund, but in me--specifically, in my stupid self-delusions
that the future would resemble the past, and that anyone could ever hope to
understand how the world's most complicated financial instruments would
behave under unprecedented conditions.
Now let's talk about the second kind of risk--poorly predicting your own
reaction to disappointment. Let's say you'd put $5,000 into Van Wagoner
Emerging Growth at the end of June, 1996. You were betting that small tech
stocks would continue the hot streak they'd been riding, that Garrett Van
continue his own hot streak (the fund was up 49.7% in just six
months), and that you had the cast-iron colon you'd need to withstand high
Then in July, 1996, small stocks crashed, and Van Wagoner Emerging Growth
plunged 18.4%. Your five thousand bucks shriveled to $4,082 in four weeks.
panicked and sold the damn thing before it could
torch any more of your money. The fund went on to have a lousy 1997, a
middling 1998--and a fabulous 1999. If you'd held on to it continuously--in
other words, if you had mastered your true risk, the risk of panicking at
the wrong time-- you'd have earned 136.9% through this week, versus 120.2%
in the S&P 500.
All this is a long answer that I can summarize quickly: The best way to
measure your investment risk is to go stand in front of the nearest mirror.
Stare into it, and think long and hard about whether you've tested your
the probability that you've analyzed an investment correctly? What's
your past record of "getting it right? What will you do if your analysis
turns out to be wrong? And how will you fight the urge to panic at the
Thinking hard about tough questions like these will do more to help you
manage your investment risk than all the quantitative measures in all the
finance textbooks at a B-school rummage sale.
Investing is not a battle against the markets; it's a battle against
yourself. The only real risk, and the only manageable one, is failing to
recognize who your true enemy is. As Pogo said, "We have met the enemy, and
he is us."
Write to Jason Zweig at firstname.lastname@example.org