Some risk measures in investing

Some people have compared a portfolio to the waves of the ocean in terms of volatility. The view is that if you own one or a few individual stocks you could lose it all (unless you are lucky or King Solomon) so you should diversify to allow investments to remain stable like the still water beneath the waves. This is why the traditional advice has been to reduce equity holdings as you age in favor of stability i.e. bonds or bond like investments.

I have described previously the application of standard deviation to investments. As a general rule, returns in the future on average fall within one SD 68% of the time and within three SD 99% of the time. As Larry Frank author of the book, Wealth Odyssey explains: “A portfolio has $100,000 in value (75% short-term bonds, 25% stocks) and a 6.29% standard deviation. Most of the time (more precisely, 68% of the time), the portfolio likely will go up 6.29%, down 6.29% or any point in between. It means at least $93,710 ($100,000 minus 6.29% of $100,000) of the portfolio is unaffected. And 95% of the time, $87,420 of the portfolio value is intact. The waves might go down three standard deviations, 18.87%; still, $81,130 of the portfolio is fine.”

I have also mentioned the Sharpe Ratio (how much return you are getting in exchange for the level of risk you are taking). The higher the ratio, the more an investor is compensated for the risk. If you go to Morningstar.com it lists, you can find it under a fund's "Ratings & Risk" tab. This is another measure that will help in assessing risk. Of course, it has downsides also. For one, it is a measure of past performance only and second when returns are low or negative in comparison with Treasuries, the ratio is hard to interpret.