The New Commonsense Guide to Your 401(k): Rebuilding Your Portfolio From The Bottom up

Chapter 46. More Tools

WHEN I WAS A BEGINNING INVESTOR, I thought the game was to find the investment with the highest possible return. That's what we all want, isn't it? Don Phillips at Morningstar taught me that if two investors assemble portfolios with the same mandate and one earns twice as much, it's because the manager took twice as much risk. If a market index of big-company stocks like the Standard & Poor's 500 Index provides a return of 10 percent over a one-year period and a mutual fund that invests in large-cap stocks returns 25 percent, that portfolio took more risk.

Professional investors use a variety of academic tools to measure risk and to analyze and compare the performance of different stocks and mutual funds. You don't need to employ these tools to invest your 401(k) money well, but I believe it's always an advantage to understand more rather than less. And a better understanding of risk can benefit you. The most common measurement of risk, and perhaps most useful to individual investors, is standard deviation, which shows how far the return of a mutual fund might be expected to deviate from its average return, based on its history. Think of a bell curve with the average—or mean—in the middle, and a wide band above and below that average. Statistics tell us that we can expect the returns of a fund to fall within 1 standard deviation from the mean two-thirds of the time. Returns can be expected to fall within 2 standard deviations 95 percent of the time.

For instance, ...