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By Jeremy Glaser and Shannon Zimmerman | 05-30-2013 12:00 PM

Getting Your Arms Around Risk

Fund investors should think beyond volatility measures alone when sizing up the risk in their portfolios, says Morningstar's Shannon Zimmerman.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Ahead of the 25th anniversary of the Morningstar Investment Conference, I'm sitting down with Shannon Zimmerman, our associate director of fund analysis. We're going to look at the best ways to think about risk in your portfolio.

Shannon, thanks for joining me.

Shannon Zimmerman: Good to be with you, Jeremy.

Glaser: Let's start with defining risk. With modern portfolio theory, risk sometimes is equated with volatility, but that might not be what a lot of investors are worried about, or what they are thinking about, when they consider risk.

How do you think about risk? Is volatility a good proxy?

Zimmerman: Well, volatility is, I guess, a kind of risk. But I think for the most part, personally as an investor and as an analyst, and when I hear from folks who read our work, the main risk that they are concerned with is the risk of permanent capital loss.

Volatility, I'll speak about that in just a minute. The risk that you're going to put your money to work in a vehicle that you hope will generate positive returns that you can rely on in retirement for big-ticket purchases--the risk that that that might not happen, in fact, you might even lose money--that's the risk that folks want to protect against the most, and rightfully so.

On the other hand, our research shows that investors by and large don't use volatile funds very well. So funds with above-average standard deviation or high beta, you need to have a high risk tolerance, a high tolerance for volatility, to use those funds successfully.

I think I may have mentioned in an earlier segment the fund Fidelity Leveraged Company stock that I cover. Terrific fund, great manager, long-tenured, and terrific long-term total return, about 14% annualized over the last decade. But the typical investor has only gotten about 2% annualized of that return, because it's so volatile.

So risk as volatility does matter, but the main risk that folks want to protect against is the risk of permanent capital loss. One thing that's always struck me as oxymoronic in the parlance of modern portfolio theory is the notion of upside risk. Investors don't really care about upside risk.

Glaser: So if you're worried about losing capital, what are some better measures other than volatility to be focused on then?

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