What a Fund's Total Return Numbers
Don't Tell You

Most investors tend to think of risk in terms of quality considerations. For example, low-quality junk bonds are "risky" and high-quality U.S. treasuries are "safe." If only it were that simple! There is another critically important component to the risk equation: time. It's not just a question of whether an investment will ultimately be rewarding (say after 10 years); you must also consider what is likely to happen to its value during the 10 year period. Circumstances may dictate a change in your long-term plan and you might not be able to hold the investment for the full 10 years. This is why a long-term Treasury bond can be a higher-risk holding than a very short-term junk bond. (See The Bond Basics You Need to Know on why bond values are hurt by rising interest rates.)

The term "volatility" refers to the extent an investment experiences dramatic price swings. To illustrate why high volatility translates into high risk, let's look at the graphs below. Most performance graphs in the financial media show "standard" one year returns (meaning they start in January and run through December). That doesn't really give you a complete picture because investors don't buy only on January 2 and sell only on December 31. The graphs below use the concept of a "rolling" year, that is, they also show 12-month periods that run from February through the following January, March through the following February, and so on. This gives you a better idea of what you might expect when holding a fund for a random 12-month period.

We've prepared an illustration using two stock mutual funds that had very similar average results over the past 10 years. The Vanguard Value Index fund is a value-oriented fund in SMI's Risk Category 1. For the past 10 years, it returned, on average, 9.38% per year. To get a good contrast, we chose Janus Research, a higher risk growth fund from Risk Category 2. It recorded similar returns of 9.97% per year during the same period. If you had to choose between them and all you knew were these 10-year performance numbers, you might think they were employing similar strategies and got similar results.

But our graphs above show that the ten years was a real roller coaster ride for Janus Research investors compared to the much steadier trip enjoyed by Vanguard Value shareholders. Each of the vertical bars in the graphs represents the return over a different 12-month period. The more violent ups and downs (or volatility) indicates a much higher degree of risk because it's always possible that circumstances (or your emotions!) will cause you to sell after a major down year.

The "relative risk" scores could have alerted you to the dramatic difference in volatility between these two funds. At 1.5, the Janus Research fund has been 50% more volatile than the Vanguard Value Index fund which carries a score of 1.0. Remember, it's not just a question of how much money you hope to make; it's also a question of how much risk you take (and how much volatility you can stomach) along the way.

See Understanding SMI's Mutual Fund "Relative Risk" Scores  for more on volatility and relative risk. Relative risk scores for over 1,000 mutual funds can be found in the Fund Performance Rankings. 

• Understanding SMI's Mutual Fund "Relative Risk" Scores 
• How SMI's "Relative Risk" Scores Alert You to Potential Losses 
• SMI's Investing Principles page

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