In investing, ‘risk’ can have many meanings: the risk of inflation, the risk of interest rates changes, the risk of currency exchange rate fluctuations, just to name a few.

One important measure of the riskiness of a stock (or mutual fund) is: How much does its value change relative to other stocks?

Which would you rather own?

Below is a graph of the S&P 500 index and the total return on a bond fund (PTTDX: Pimco Total Return).  Each line was normalized to 1 at the beginning.  If you made either investment in June 2002 and held it for six years, you would have had about a 35% total return on your investment.  Both investments end up at the same point.

If you had chosen to hold bonds, you would have watched your investment slowly rise over time.  By contrast, if you had chosen to hold stocks, you would have watched your investment lose about 20%, experienced the thrill of it rising to a 50% overall return, only to decline back down.

Which investment you prefer says much about your overall view of investing.  Do you like to “set it and forget it” or are you seeking thrills in the market?  There is no absolute right or wrong answer.  Personally, I sleep better with slow and steady gains.  It gives me fewer bragging rights around the water cooler, but I invest for myself and my family.  I’ll do my bragging in 20 years.  I can live with that.

The volatility of individual stocks

While the stock market is more volatile than bonds, individual stocks are more volatile than the overall stock market.

The next graph compares bonds, and the S&P 500 to Borders (BGP) over the same period.

During this time period, the value of Borders’ stock oscillates wildly.  An investor would need a strong stomach to ride the wild ride.  Measures of the overall market, like the S&P 500 index, average the performance of many invdividual stocks, neutralizing much of the short-term volatility.

The technical measure of volatility is beta which compares  an individual stock (or mutual fund) to the overall market.  If a security rises and falls exactly with the overall market, it has a beta = 1.  For example, Morningstar calculates beta for the Vanguard S&P 500 Index Fund (VFINX) equal to 1.00.  If a stock or fund less volatile than its index, beta is less than 1 but greater than 0.  Beta is calculated relative the relevant index.  For example, Morningstar calculates beta for the bond fund (PTTDX), above, against the US Aggregate Bond Index, and it has a beta of 1.03.

Risk is an important consideration in the selection of individual securities as well as in the overall development of your portfolio.

What is your tolerance to risk?  Are you a tortoise or a hare?

Full disclosure: Long in PTTDX and VFINX.

Tags: PTTDX, risk, stocks vs. bonds, VFINX, volatility

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