How do you measure risk?

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How do you measure risk?

Postby lucky3 » Sat Jan 26, 2013 4:09 pm

This might be a basic question for most of you but how exactly do you measure the amount of risk in a fund?

My wife is transferring a 5 figure Magellan traditional IRA to either a Star IRA from Vanguard, which she already has OR a new Vanguard Total Stock Index fund.

Seems to me that STAR and the total stock index fund are pretty similar when risk is being measured...yes or no? She's almost 70.

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Re: How do you measure risk?

Postby dbr » Sat Jan 26, 2013 4:12 pm

You can open a can of worms over this, but the financial analysis standard definition of risk in an investment is the standard deviation of annual returns.
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Re: How do you measure risk?

Postby richard » Sat Jan 26, 2013 4:13 pm

There is no good quantification of risk. Standard deviation is often used, but that's mainly because it's easy to calculate, not because it's a good measure of risk.
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Re: How do you measure risk?

Postby dbr » Sat Jan 26, 2013 4:19 pm

lucky3 wrote:This might be a basic question for most of you but how exactly do you measure the amount of risk in a fund?

My wife is transferring a 5 figure Magellan traditional IRA to either a Star IRA from Vanguard, which she already has OR a new Vanguard Total Stock Index fund.

Seems to me that STAR and the total stock index fund are pretty similar when risk is being measured...yes or no? She's almost 70.

Lucky3


Vanguard rates STAR a 3 and TSM a 4 on risk.

STAR is only 63% stocks and TSM is all stocks. Those funds are definitely not pretty similar when risk is being measured.
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Re: How do you measure risk?

Postby LadyGeek » Sat Jan 26, 2013 4:33 pm

Measuring risk, let alone defining risk, is a bone of contention for this forum.

You're primary concern is not measuring risk, but maximizing your total return. Long story short, you are looking at transferring into funds with different asset allocation percentages - which is used to set your level of risk tolerance (how much can you afford to lose).

To add to dbr: Vanguard Total Stock Market Index Fund Investor Shares (VTSMX) = 4 (100% stock / 0% bond), Vanguard STAR Fund (VGSTX) = 3 (60% stock / 40% bond).

The wiki can give you better insight on the importance of asset allocation in terms of risk: Risk and return: an introduction

Your goal should be to configure your transfer so that the overall portfolio meets your desired level of risk, meaning your ratio of stocks/bonds. There's not much more to it than that. You'll be fine if you want to stick with the STAR fund.
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Re: How do you measure risk?

Postby nisiprius » Sat Jan 26, 2013 4:54 pm

I like Vanguard's risk scale. I don't honestly think you can make finer distinctions than that. But you need to be alert for the fact that they're categories, not linear! Total Stock with "risk potential 4" is much more than "twice as risky" as Total Bond with "risk potential 2."

I'm pretty sure that Vanguard uses some simple qualitative rules for assigning those categories, though I haven't reverse-engineered how they decide between 4 and 5. I'm guessing that if Vanguard tried to categorize Magellan on their scale, being a broadly diversified 100%-stock fund, they would put it into category 4, same as Total Stock. I think this because many of Vanguard's actively-managed broad 100%-stock funds, like WIndsor, Diversified Equity, and Morgan Growth go into category 4, and also because Magellan has (alas!) behaved a lot like the S&P 500 and/or Total Stock, which are in category 4.

I also like this exercise. Find a growth chart, as long as you can find, and preferable a dynamic one where you can slide the mouse along and watch the totals go up and down. You can do this for Vanguard's funds at its own website, e.g. the Price & Performance tab for STAR, here, and then add Total Stock for comparison. I slide the mouse along, I watch the numbers, and I commune with myself and ask myself very seriously--"how would I really feel about seeing $19,500 in my account one day...
Image

...and then seeing $17,270, two thousand dollars less, just a couple of months later? This is risk as actually experienced by the investor.

Image

Vanguard lets you add up to two other funds for comparison, and if you add Total Stock I think you'll see that Total Stock obviously fluctuates more than STAR. And you can go to Morningstar.com and get growth charts for more than one company, that go more than ten years back.

My personal favorite "measure of risk" is very simple. By what percentage did the fund fall between 12/31/2007 and 2/28/2009? If we look at Magellan, Total Stock, and STAR, and use Morningstar's feature that lets us set the $10,000 starting point at any date we like, I see this:

Image

(Morningstar's growth charts are free, you do not need a paid subscription, and instructions for using them are on the Bogleheads' Wiki here).

Most broad stock funds dropped "about 50%." We see that Total Stock dropped 48%. Magellan dropped 57%, shame on Magellan, boo, hiss! And, again, it is clear that STAR, which only dropped 34%, was less risky than the others. The reason, of course, is that STAR is a balanced fund that contains both stocks and bonds, and is expected to have both less risk AND less return.

And then there's standard deviation. Standard deviation is a mathematical measure of fluctuation or volatility, and it's most intuitively meaningful when it is measuring things that are statistically "better behaved" than financial data. But you can do math with it, and it's useful in two ways. First, it goes into calculating the Sharpe ratio, which is a measure of risk-adjusted return. It is very easy to think that one fund is better than another because it has had higher returns, but it isn't really if it also had higher volatility, and standard deviation can be used to measure that. The second thing is that it is one of several numbers that are input data in calculating "efficient frontiers" and applying modern portfolio theory (MPT) and generally following a strategy which some Bogleheads call "slice and dice." Under the right circumstances, MPT says that the whole can do a little bit better than the sum of its parts, and that by blending uncorrelated assets you can sometimes improve return in relation to risk, and standard deviation is one of the numbers that goes into that strategy.
Last edited by nisiprius on Sat Jan 26, 2013 5:11 pm, edited 5 times in total.
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Re: How do you measure risk?

Postby nisiprius » Sat Jan 26, 2013 5:06 pm

At age 70, your wife needs to decide what her overall stock/bond allocation should be, adding up all of everything she has in every account. She really needs to decide this (somehow) for herself, knowing her own risk tolerance and not letting anyone else tell her how tolerant she should or should not be. This next chart is a sort of sampling of conventional wisdom. The three S-shaped curves are Ibbotson/Morningstar''s "glide paths" for adjusting stock percentage with age. Almost all "target-date retirement funds" offered by fund companies lie somewhere in between the red and purple curves. The dotted line is "age in bonds," which used to be a popular rule of thumb; which John C. Bogle likes; and which is often mentioned as a guideline on this forum.

Image

Nobody can tell your wife whether she should be conservative, moderate, or aggressive. What can be said, however, is that if the only mutual funds she owns are Magellan and Star, well, Magellan is 100% stocks and STAR is 60% stocks, so she must be somewhere between 60% and 100% stocks, depending on how much of each she has.

Well, even 60% stocks is a lot of stocks for a 70-year-old. Look at the chart. A 70-year-old following "age in bonds" would have only 30% stocks. A 70-year-old following one of Ibbotson's glide paths would be about 22% stocks (conservative), 37% (moderate), or 52% (aggressive).

Now maybe there are some conservative holdings you haven't mentioned. But she really does need to know a) her overall portfolio and the percentage of it that is in stocks, and b) what she wants her percentage of stocks to be. 60% stocks or more would be a very aggressive, stock-heavy portfolio for a 70-year-old.
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Re: How do you measure risk?

Postby livesoft » Sat Jan 26, 2013 5:10 pm

I like to look at morningstar growth-of charts just like nisiprius presented for various asset classes and funds. I represent "risk" as how much value a fund lost from October 2007 to March 2009. The ones that lost the mostest are riskiest. It is really that simple.
It's all about short-term opportunistic rebalancing due to a short-term change in one's asset allocation, uh, I mean opportunistic rebalancing, uh I mean rebalancing, uh I mean market timing.
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Re: How do you measure risk?

Postby bertilak » Sat Jan 26, 2013 5:30 pm

nisiprius wrote:60% stocks or more would be a very aggressive, stock-heavy portfolio for a 70-year-old.

Unless she has lots of income from other sources. She could then afford the risk. Her investment horizon might still be fifty years or more if she is thinking in terms of a legacy so that risk might be prudent.

If she has little income from other sources she might want to be much more conservative.
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