Measuring a Fund's Risk and Return
  1. Perspectives on the Risk-Return Relationship
  2. Understanding Mutual Fund Returns
  3. Fund I-Q No.2: Favorable Risk-Return Profile
  4. Scoring Risk-Return Data

Perspectives on the Risk-Return Relationship

By Richard Loth (Contact | Biography)

"The history of the stock and bond markets shows that risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns." -William Bernstein, "The Four Pillars of Investing" (2002)

Investment research studies throughout the years have confirmed that the general investing public, or non-professional investors, have a pronounced tendency to focus on an investment's return. While risk is not necessarily ignored, it certainly seems to play second fiddle to return in most individual investors' decision-making processes.

As applied to mutual funds, you will learn the importance of the risk-return relationship in selecting quality mutual funds. In addition, we will explain the importance of understanding the concept of total return, which is the key component of a fund's investment performance. (For more insight, read Determining Risk And The Risk Pyramid.)

We'll also identify an discuss the significance of a favorable risk-return profile as one of the more valuable investment qualities to be considered in selecting a mutual fund.
In the investing world, there are a number of highly technical, sophisticated metrics that are used to measure investment risk-return. The most commonly used of these indicators include alpha, beta, r-squared, standard deviation and the Sharpe ratio. (For background reading, see Five Stats That Showcase Risk.)

Calculating and Interpreting Risk Measurements
It is safe to say that few, if any, non-professional investors, have the faintest idea how to calculate and/or interpret these measurements. That is the so-called bad news. The good news is that Morningstar and Value Line fund reports do all the statistical analysis for us and provide easy-to-understand risk and return evaluations. Essentially, these come in five different varieties: high, above-average, average, below-average, and low, or words to that effect.

It is a universally accepted principle of investing that risk and return are commensurate. This fancy terminology simply tells us that the level of risk determines the level of return. As a result, it is unusual that a low-risk investment will produce a high return. Of course, the inverse of this relationship is also true.

Asset Allocation and Diversification
Prior to selecting individual mutual funds, or any other investment, for a portfolio, an investor should decide on an appropriate asset allocation. For the sake of this discussion, let's say that a moderate 60% stock and 40% bond apportionment is made. Diversifying within these allocations then requires that the investor select investments (funds, stocks, and/or bonds) that are complementary this moderate risk-return investing strategy. (For more insight, see Achieving Optimal Asset Allocation.)



Risk is an inherent part of investing. In order to get a reasonable return on an investment, risk has to be present. A riskless asset will produce little or no return. The intelligent investor manages risk by recognizing its existence, measuring its degree in any given investment and realistically assessing his or her capacity to take risk. There is nothing wrong with investing in a high-risk fund if the fund's return is equally high. The questions to ask are: Can I afford the loss if it occurs? Am I emotionally prepared to deal with the uncertainties of high-risk investments? Do I need to take this kind of risk to achieve my investment goals? (To help answer these questions, read Personalizing Risk Tolerance.)

A prudent investor will seek to match and/or offset risk by assembling a reasonable number of mutual funds with favorable risk-return profiles in a diversity of fund categories. This is done by first identifying a mix of mutual funds according to company size (market-cap), investing style (value, growth, and blend) and asset allocation (stock and bond). By choosing from these funds, you can find those that are characterized as having returns that exceed their risks, or at least match them. This would represent a favorable risk-return profile, or spread, and is a key fund investment quality.

Return to the Main Menu.

Understanding Mutual Fund Returns

  1. Perspectives on the Risk-Return Relationship
  2. Understanding Mutual Fund Returns
  3. Fund I-Q No.2: Favorable Risk-Return Profile
  4. Scoring Risk-Return Data
RELATED TERMS
  1. Risk-Return Tradeoff

    The principle that potential return rises with an increase in ...
  2. Aggressive Growth Fund

    A mutual fund that attempts to achieve the highest capital gains. ...
  3. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected ...
  4. Mutual Fund Yield

    Dividend payments divided by the value of a mutual fund’s shares. ...
  5. Survivorship Bias

    The tendency for mutual funds with poor performance to be dropped ...
  6. Exchange-Traded Mutual Funds

    Investopedia explains the definition of exchange-traded mutual ...
RELATED FAQS
  1. How do I judge a mutual fund's performance?

    Evaluate mutual fund performance utilizing resources such as Morningstar; compare the fund with others in its peer group ... Read Answer >>
  2. How much of a company's stock can a mutual fund own?

    There is no written rule that stipulates how much of a company a mutual fund can own. Instead, there are two major factors ... Read Answer >>
  3. How do I calculate the loan-to-value ratio using Excel?

    Learn what a mutual fund and a money market fund are, and understand the differences between each and how they serve various ... Read Answer >>
  4. What metrics should I use to evaluate the risk return tradeoff for a mutual fund?

    Understand the key metrics used to analyze mutual funds and how investors can use each measurement to determine the risk-reward ... Read Answer >>
  5. Why don't mutual funds trade like stocks?

    Learn how mutual funds differ from exchange-traded funds (ETFs) in how they are traded. Also, learn what fees are involved ... Read Answer >>
  6. Can mutual funds invest in hedge funds?

    Learn about mutual fund portfolio management techniques and mutual funds' ability to invest in hedge funds, as well as new ... Read Answer >>

You May Also Like

Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center