Risk is easy to ignore when funds are on the way up, but when markets fall, risk is suddenly right in your face. There are two useful quantitative measures of risk, both calculated based upon monthly fund returns for the last three years.
Beta is a measure of a fund's return sensitivity to the returns of the overall stock market, and works well as a risk measure for diversified funds. The higher the beta, the higher the volatility, and therefore risk. Beta can range from very large negative numbers to very large positive numbers, theoretically, but most stock mutual fund betas cluster in the range of 0.5 to 1.5. A zero beta would imply no sensitivity to the stock market, and would more likely belong to a money market fund than a stock fund. A negative beta indicates that, on average, the fund and the market move in opposite directions—also an unlikely figure for any stock fund. The stock market's beta is by definition always 1.0; a fund with a beta of 1.5 is expected to be 50% more volatile than the market, and a fund with a beta of 0.5 would be only half as volatile. For instance, if the market rose 20%, a fund with a beta of 1.5 would be expected to be up 30% [20% + 0.50 (20%)] and if the market fell by 20%, the fund might drop 30%. When two stock funds with similar returns are considered, give a nod to the one with the lower beta.
A second measure of risk is standard deviation, a barometer of volatility from any source, rather than just the stock market. Numerically, standard deviation is less intuitive than beta, but the higher the standard deviation, the greater the risk. Beta assumes a diversified portfolio so that other factors—such as the risk unique to individual stocks and industries—is virtually eliminated, leaving only the risk of market moves. Standard deviation works for all portfolios, diversified or not, and captures the risk from all elements.
If the two funds have similar returns, but are not well diversified, you cannot count on beta. Pick the fund with the lower standard deviation.
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