Strictly speaking, risk refers to the chance that an investment’s actual return may be different than expected, and includes the possibility of losing some or all of your original investment. Knowing that, how can you assess your own risk tolerance?

Investment professionals use a variety of risk questionnaires, with mixed success. The problem is that questions about one’s capacity for risk (i.e., financial situation) are often tossed in with questions about attitude toward risk (willingness to accept the accompanying uncertainty and anxiety). In a recent Investment Advisor article, Michael Kitces, CFP, CLU, and director of research for Pinnacle Advisory Group, suggests a third factor: perception of risk, which can change from week to week and headline to headline.

When an investor’s answers involving all these variables are averaged, the “risk score” that emerges may well be useless. For example, a 50ish worker without much savings may be wary of risky investments, even though his only hope of reaching his goals is to take on more risk. What’s his risk tolerance? Conversely, someone who has built up a sizable nest egg through aggressive investing may enter retirement still fixated on investing aggressively – although the associated risk could actually destroy her financial security. Is her risk tolerance high or low?

Kitces recommends addressing the different faces of risk on three fronts:

1. Education to correct faulty perceptions. A red flag should pop up when an investor starts to imagine, “This time it’s different.” In 1999, people thought risky tech stocks had suddenly become safe. In 2005, it was widely assumed that home values would continue increasing by 8% to 20% a year. Investors can often benefit from more research (or cautionary words from an advisor) to adjust their own risk perceptions before they leap.

2. An objective look at risk capacity. This is familiar personal-finance territory, involving length of time to retirement, availability of guaranteed income, ability to self-insure for long-term care, and so on. Advisors can add Monte Carlo projections to estimate portfolio performance.

3. A separate assessment of risk attitude. This is what makes one investor fundamentally uncomfortable with high-risk derivatives, and drives another to distraction at the thought of super-safe investments and allocations.

It may seem that the worst possible risk is failing to reach your goal. But as Kitces and others advise, don’t react by creating a portfolio that crosses the line into causing intolerable fear and anxiety. Your aim is to take intelligent risk – and by carefully considering its different faces, you’re more likely to manage it well.

NAV is calculated as follows:
NAV = (Total Asset Value – Operating Expenses) / Number of Units

For example:
If a mutual fund’s assets consisted of 10 shares and yesterday’s closing price per share was $500, then the fund’s total asset value would be $5000. Assume now that there are 1000 units in the fund, and that it costs $100 to operate the fund. The fund’s NAV would be $4.90.

NAV is the price of one mutual fund unit. Therefore, in the above example the price for one unit is $4.90. If the price of the shares held by the fund moved from $500 to $600, then the fund’s NAV will increase from $4.90 to $5.90. If you owned one unit in that mutual fund you would be $1 or 20% richer.

So can you use NAV to measure a fund’s performance? Yes, but it is not the best measure of performance. Mutual funds generally distribute capital gains and income earned to investors. A fund’s NAV will decrease when the fund makes distributions because assets are leaving the fund. If a fund with an NAV of $5.90 makes a $2 distribution, its NAV will drop to $3.90. Despite the lower NAV, investors are no worse off. They still have $5.90, made up of $3.90 invested in the fund and $2 in cash. Investors can then decide whether they wish to reinvest the $2 back into the fund by purchasing additional units at the current market price ($3.90) or to keep their $2 cash.

Changes to a fund’s NAV are therefore not a good measure of a fund’s performance. Total return is a better measure of performance as it takes all of a mutual fund’s returns into account, including capital gains and income for a given period, less operating and marketing expenses.

The take-away for investors:
NAV is the price of one mutual fund unit. NAV measures the value of the assets held by a mutual fund on a per unit basis. This is important to investors since they are investing with the expectation that these assets will increase in value. That said, NAV is not the best measure of performance because a fund’s NAV will decrease when the fund makes a distribution. So when evaluating a mutual fund’s past performance, rather look at total returns.

Mutual funds are typically classified according to the types of assets they invest in. There are three main types of mutual funds: stock funds; bond and income funds, and balanced funds. As the names indicate, a stock mutual fund invests predominantly in stocks, a bond fund in bonds, and a balanced fund strikes a mix of both. Stock funds typically carry more risk than bond and balanced funds, and are better suited to investors who may be willing to accept a higher level of risk in order to improve their potential returns. More conservative investors may wish to focus on bond or balanced funds, depending on their investment objective and the level of risk they are willing to accept.

So where do you fit on the scale, and how might that impact your choice of fund? Here are some basics to consider:

• Protecting the value of your investment is your main concern, while potential returns are secondary. If this describes your objectives, then you are looking for a conservative investment. You are hesitant to take on risk, to the point that you are willing to accept limited returns over the possibility of losing a large portion of your money. You should give a higher priority to low volatility, predictability and consistency of returns. Bond funds are generally an attractive way to meet this objective.

• Protecting the value of your investment is important to you, but you’re willing to accept higher risk to increase potential returns. This describes a stable investment that is moderately conservative. Your primary focus is to limit the volatility of returns; you are however willing to accept some risk in order to earn a higher return (compared to preserving capital). Higher risk diversified bond funds or lower-risk balanced funds are attractive choices to meet this objective.

• Protecting the value of your investment and higher potential returns are equally important to you. This points to a “balanced” investment which aims for a middle ground between preserving money and growing it. You are open to taking on a moderate level of risk, and are more concerned with the potential for modest growth than with predictable returns. Hybrid funds or balanced funds are attractive choices to meet this objective. The relative weighting of stocks and bonds in the fund will depend on your risk preferences and the length of time you plan to hold this investment.

• The longer-term potential returns of your investment are more important than protecting the short-term value of the investment. This represents a “growth” investment that focuses on achieving higher possible growth. In order to do so, you must be willing to take on a greater amount of risk. Higher-risk balanced funds and lower-risk stock funds are attractive choices for this objective.

• High longer-term potential growth is your main concern, while protecting the short-term value of the investment is of low importance. If this is what you seek, then an “aggressive growth” investment may be for you. This type of investment focuses aggressively on achieving the highest possible growth. In order to do so, you must be willing to take on a significant amount of risk. High-risk stock funds are attractive choices for this objective.

So before you jump in, take time to consider which of the above best describes your objectives for your particular investment. It’s a fundamental step towards to making a fund selection that is better suited to your specific preferences and goals.

One of the recent posts on My Money Blog highlights the best rates for online savings accounts. The blog states the following:

“Here are accounts that represent the range of the best current rates.

Everbank is offering 2.51% APY for the first 3 months for new accounts (now 2.25%). This rate is higher than any 3-month certificates of deposit currently available, which being available for withdrawals at any time. The rate is guaranteed stay in the top 5% of competitive accounts.

Alliant Credit Union has a non-promo savings account rate of 2.00% APY. Membership is restricted to people with affiliation to a qualifying organization, but the cheapest way around this is to become a member of a PTA or PTO.

Ally Bank Online Savings offers their “no fine print” savings account rate to 1.49% APY as of 1/5/09. No minimum balances, no monthly fees.

Veteran online bank ING Direct holds up the lower end at 1.30% APY.”

It’s true these rates seem low, but that’s a reflection of the current interest rate market. When compared to traditional banks like Wells Fargo/Wachovia which are offering 0.9% on money market savings accounts, these rates are relatively good. The Everbank and Ally offerings both seem reasonable and straightforward, so what’s to choose between them?

Here are a couple of factors to consider when deciding on offers such as these.

Over a short period of three months, Everbank’s offer is clearly better at the promotional rate of 2.25%. The Everbank offering also looks to be slightly better when calculated over one year – it averages out at around 1.51% APY against the 1.49% offered by Ally. However, the Everbank promo rate applies to balances up to a maximum of $50,000. Additional funds attract interest at 1.25%.

On the other hand, the Ally offering has no cap, and applies to your entire balance. So the Ally offering will improve over the Everbank deal on larger sums of money over the longer term – that is to say, sums reasonably in excess of $50,000 and over periods longer than a year. It’s a relatively easy calculation to make depending on your specific circumstances.

So when deciding on which savings account to choose for your cash holdings, consider – among other factors such as fees – whether a cap applies to the promotional rate, how much money you wish to hold in cash and for how long.

And, finally, shop around. The Internet is a great resource for obtaining information on the best possible rates. As one of the readers on My Money blog noted, there’s an offer from Capital One/Costco at 1.65% APY. So if you’re a Costco member, that might be the way to go.

Jemstep has no affiliation with any provider mentioned in this article.

Do you understand the risk associated with your mutual fund’s returns?

Given the destruction of value that we’ve seen over the past 18 months on the stock market, most investment portfolios have taken a beating. Thankfully, the past few months have seen a strong rally in the stock market but over a 3, 5 and 10 year period the Standard & Poor’s 500 index (an index of 500 widely traded large-cap stocks) is still in negative territory. There was a period during late 2007 and early 2008 when investors could purchase just about any mutual fund and see its value rise rapidly as the bull market charged on. Unfortunately in many cases these investors neglected to understand the volatility associated with these fund’s returns…. as the saying goes: easy come, easy go.

While this article is intended to help understand the risk adjusted returns of a mutual fund, I thought it would be interesting to contextualize this by focusing on those funds that have managed to defy the odds and perform strongly when so many other funds have struggled. I’ll then take a closer look at these funds to ascertain the level of risk associated with their returns.

Which funds have performed well over the past 3 years?

When ranking over 17 700 funds on their 3 year annualized return, the top 3 performers (according to Jemstep) have been as follows: In first place the Dreyfus Greater China Fund (DPCRX) with an average annual return of 19.78%*, followed by another Dreyfus fund, the Dreyfus Greater China A Fund (DPCAX) with 19.46% and in third place we have the Aim China I Fund (IACFX) with 18.68%. China it would seem has been the place to invest. All these funds have managed to return over 18% which is phenomenal when you consider that an investment in a US index tracking fund such as the Vanguard 500 Index Investor (VFINX) has delivered a very poor return of -8.27% over the same period. While percentages can sometimes be misleading, an investment of $ 10 000 in the Dreyfus Greater China Fund (DPCRX) made 3 years ago would currently be worth approximately $ 17 185 while an investment in the Vanguard 500 Index Investor (VFINX) would only be worth approximately $ 7 719. The numbers speak for themselves.

Hindsight is an exact science and on a pure return basis the Dreyfus Greater China Fund (DPCRX) would clearly have been the best fund to invest in 3 years ago, but would it still have been the best investment to make when we add the fund’s risk/volatility into the equation? In other words, when focusing on the risk adjusted return would the Dreyfus Greater China Fund (DPCRX) still have been the best fund to purchase 3 years ago? In order to answer this question we need a basic understanding of a fund’s risk.

Determining a fund’s level of risk

When you go to a roulette table and you want to bet on which color will come up, red or black, you can work out exactly what your odds are of winning. There are 37 potential outcomes (0 to 37) of which 18 are red, 18 are black and 1 is green. Once you know this, it is easy to calculate that you have less than a 50% chance of winning 18/37 (48.65% to be exact) and as your payoff is only 100%, in the long run the odds are stacked against you and you are destined to lose. Thankfully investing doesn’t have to be as risky as playing roulette, and – just like in roulette – there are statistical measures in investing that can assist you in determining which funds carry more risk (volatility) then others.

A simple measure of risk

While there are a number of statistics that measure the risk associated with a fund, in this example I will be focusing on standard deviation as a well known measure for this purpose. Although the name may sound complex, this measurement is a simple number that represents the historical volatility of a fund’s returns. Quite simply, the higher the number, the higher the volatility of a fund’s returns and therefore the higher the risk associated with the fund.

How does it work?

If a fund has a three year average annual return of 10% and a three year standard deviation of 25%, then two thirds of the time the fund’s annual return can be expected to fall between-15% and 35%. How is this calculated? Take the fund’s average return, 10% and add and subtract the standard deviation to find the range of expected returns. For example 10% – 25% = -15% and 10% + 25% = 35%. Therefore we have an expected range of -15% to 35%. In summary, standard deviation indicates the range a mutual fund’s return can be expected to fall two thirds of the time. Remember the higher the number, the larger the expected range, so the more volatile a fund’s returns are expected to be.

In the example above, while some investors have a higher risk profile and are willing to invest in very volatile funds in order to maximize their returns, more conservative investors would suffer endless sleepless nights if they were invested in a fund where their potential returns could range between -15% and 35%.

Bringing it all together

From the table above it is clear that:

• Fund B has performed better then Fund A over the past 3 years: past performance 13% > 10%
• Fund A has been less volatile/risky then Fund B: standard deviation 7 < 8.5

But which fund has performed better on a risk adjusted performance? To answer this we need to do a very simple calculation to work out which fund generated more return for each unit of risk.

Return per Unit of Risk (RUR):

Once we’ve done this calculation it is clear that Fund B offers the best risk adjusted performance.

It’s important to note that if the annualized return is greater than the standard deviation, the return per unit of risk ratio will be greater than 1. A ratio above 1 indicates that you are being adequately rewarded for the risk (as measured by standard deviation) associated with the fund, conversely a ratio of less than 1 may indicate that the fund in not producing a high enough return given the risk or volatility of its return.

Now, let’s take another look at the three top performing funds over the past three years. We asked the question whether these funds would remain the best performers after we added risk into the equation. Let’s have a look at the results.

The most obvious area of concern in the table above is that the highest return per unit of risk ratio is only 0.51. Therefore the numbers suggest that although these funds were the best performers over the past 3 years, their returns were extremely volatile. As the graph below clearly illustrates, being invested in the Dreyfus Greater China I (DPCRX) over the past 3 years has been a wild ride and certainly not one for the faint hearted. The fund has touched highs of $ 57.53 and lows of $ 16.27. In fact, if we had performed this exercise in late 2008 or early 2009, the fund’s three year performance would have been deep in negative territory.

3 year price history for the Dreyfus Greater China Fund I (DPCRX)

Top performers – risk adjusted returns

So which funds have produced the best risk adjusted returns over the past 3 years? In order to calculate this you can simply use Jemstep’s Expert mode setting and ensure that you slide the 3 year standard deviation and 3 year total returns sliders all the way to the right. This efficiently ranks which funds have produced the highest return per unit of risk or, in other words, which funds have produced the highest returns with the lowest volatility. The results are as follows:

The above ranking suggests that on a risk adjusted basis the best performing funds over the past three years have been bond funds. Note that all of the above funds have a return per unit of risk ratio well in excess of 1 – this compares very favorably when compared to the high flying top performers over 3 years. In fact, Jemstep shows that once we add volatility/risk into our ranking, the Dreyfus Greater China Fund I (DPCRX) falls from first place to number 8 441 out of 17 700 funds. This is a drastic fall and a clear indication of how volatile/risky the returns have been with this fund.

So before you rush out to buy a “top performing fund” make sure that you are aware of the risks associated with the fund.

As the recent months have shown, it’s up to each person to take some responsibility for their own financial affairs. If you use a broker or financial advisor, you should be more active in guiding the final investment decisions that are made.

The question is – how can you do this if you are not a sophisticated investor? Well, Jemstep helps you in precisely this situation. Let’s say a mutual fund has a superior return over the past three years, and is recommended to you by your broker. Traditionally you may have simply relied on your broker ‘s judgment and proceeded with the investment. But now you can validate recommendations in an instant, taking your specific preferences into account.

Simply search for the mutual fund on Jemstep, input your preferences and in a split second you will see where that fund ranks in the entire mutual fund universe. Out of approximately 18,000 mutual funds, let’s say this one pops up at #16,072. You check out the details and realize that although its return is superlative, this fund’s level of risk is too high for you. You call up your broker and give him the information – or simply share it with him on Jemstep using our collaboration tools. You can also both see which fund was ranked #1 by Jemstep and why. Now you can start a constructive discussion, and hopefully arrive at the best choice for you.

So if you don’t decide to go it alone just yet, with Jemstep you can participate meaningfully with your broker in choosing the best investments to suit your profile.

We are still in private alpha testing, but will be bringing you our beta version (with mutual funds) in the near future. We’ll keep you updated on progress!

Those who have registered for our Beta version will be justly rewarded for their patience by having first access to the beta version in the near future. Its not too late for anyone still wishing to register for our Beta – you may do so by clicking here.

At the moment our Alpha version has been limited to credit cards and mutual funds. By the time our Beta version is available, we anticipate having several more exciting products online and ready to help you with your financial and investment choices.

So please check back regularly for updates. For any further information, please don’t hesitate to contact us at: info@jemstep.com.

If there is any specific product you would like to see introduced by Jemstep, please let us know in the Feedback section of our site. In the meantime, we invite you to see how Jemstep’s unique approach empowers you to make smart life decisions, and we look forward to your feedback. If you have not signed up for the beta version, you may do so here.

Fortunately, if you rely on Jemstep, you’ll stay one step ahead of the fine print.

Let’s see how Jemstep works its magic, with a short walkthrough of this Live Ranking tool for credit cards. (The Jemstep alpha also includes a ranking tool for mutual funds, which we’ll discuss in our next post.)

If you are an alpha user, log in to Jemstep now. (If you’re not an alpha user, you can register for the Jemstep beta version here.)

Select the Credit Card tab, and then take a look at My Credit Card Preferences. There are five sections for you to enter preferences, with more dozens of criteria overall-everything from your credit score to preferred balance transfer features to the types of rewards you’re interested in.

Don’t be daunted by the scope of possible preferences though. Enter only what you want, and watch Jemstep dynamically tailor its rankings for you. You can narrow the field by limiting your rankings to a particular institution, or experiment with different usage scenarios, such as how much of your balance you pay off every month.

When you’re satisfied with your preferences, your custom-built list of credit card rankings is ready to explore. Start with your #1-it’s the one that best suits your needs. You can get details about a card, add it to your profile, and even apply for the card.

If you want information about a specific card you already own, or one you’re considering, enter the name of the card under My Stuff. Jemstep will rank the card and show you how it matches up to the competition.

To top it off, when you add a card to your LifeData profile, Jemstep continually monitors details about the card, keeping track of all those “gotchas,” such as new fees and interest rate changes, that have caught a lot of people by surprise.