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When you compare one fund to another, most people just look at their returns. (Total returns over a period of time, or equivalently, CAGR over the same period of time. We won't even mention the phony "Average annual returns" measure that mutual fund companies use when they advertise.)

However, that's not the whole picture. Some funds only achieve their high return by taking on excess risk. So you have to also consider some measure of the riskiness of the fund, however you choose to define it. Modern Portfolio Theory looks at derived statistics like volatility, Sharpe Ratio, and a whole buncha Greek letters. They even come up with something known as "Risk-adjusted return" -- which I guess is something similar to "If we held X dollars of this fund and $10,000 - X of cash so that it had the same risk (uh, volatility) as the total market, what would the return be?"

This is too complicated for some people, and there are various ways of trying to simplify it. Some websites show a "speedometer" style graph showing whether a fund is less risky, as risky, or more risky than the appropriate total market. Others try to break things up into boxes. Morningstar has the widely known "Star" system where each fund is awarded 1 to 5 stars based on both its performance and risk during some specified past time period.

Why is risk something to be avoided? Well, the risks that worked out for them last year are not going to be the same risks that work out for them next year. The market giveth and the market taketh away. Folks who are withdrawing from their portfolio need to be especially risk averse because any drop in their portfolio causes them to drain their reserves faster.

Even people who aren't forced to withdraw should use some risk management, because of the emotions involved. Most people can't viscerally handle the sight of 50% of their money just disappearing (even if it was after a 100% gain).

Recently we were discussing Joseph Shumpeter's quote, and we concluded that for someone withdrawing from his portfolio, the only safe withdrawal rate is the risk-free interest rate, even if the portfolio has a higher return. Down times will eventually come and he need to have something in reserve for those times. If he spends the whole amount of the increase, he'll be sorry later.

Back when I first started investing, my thought was "Get the riskiest legitimate investments I can find, since even if I get wiped out, since I don't have much in there, and I'm contributing a lot each year, it won't put off early retirement by that much time." But I realized that it was hard to tell risky investments from just plain phonies. I steered clear of the NASDAQ (good thing, too...I was way off on my forecast of the dotcom crash).

[Funny. I still haven't invested a lot (my net worth is less than my salary) but now I am already seeing the "preserve wealth" instinct kick in. If I'd known in 1999 I'd have had this much in bonds and cash in 2002, I would've been shocked.]

Anyway, back then I was contemptuous of the very concept of "risk-adjusted returns". My logic ran, "You can't spend a lack of risk." Well now thanks to the Shumpeter discussion I know that's faulty logic. When you're spending, lack of risk is very important!

However, is this necessarily the case for someone who is not spending, but is constantly adding to the portfolio (perhaps with an eye to keeping percentages in balance)? I'm still at the stage where the money I add to the portfolio vastly outweighs any internal increase in the portfolio's value.

So, I am once again searching to see if risk-adjusted returns are meaningful to me. I suspect they're not, but I'd like to know why.
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