GAUGING THE RISKS OF INVESTMENTS

To evaluate the potential risk—and return—of a particular investment, many financial analysts look at a security's long-term history. They calculate the security's volatility under changing market conditions.

In an effort to evaluate the market as a whole, several companies have developed various measures. The Dow Jones Industrial Average, for example, tracks the performance of the stocks of 30 large, successful companies. Other common measures of the overall price movement of stock listed in the U.S. include the Standard & Poor's 500 Index and the NASDAQ Composite Index.

Analysts use measures of variance such as standard deviation and beta to describe a security's volatility. While standard deviation is an absolute measure of volatility, beta is a relative measure of volatility. Standard deviation is a statistical measure of how much an investment's return varies from its average return over time. The beta coefficient measures the price variance of a stock compared to the market as a whole.

The Standard & Poor's 500 Index has a beta of 1. A stock with a beta that is higher than 1 will be more volatile than the market as a whole.

The aim of all these calculations is to create an efficient portfolio.

An efficient portfolio demonstrates the largest expected return given a particular level of risk.

Conversely, an efficient portfolio also demonstrates the minimum level of risk for the return expected. Combining investments whose prices tend to vary in opposite directions lowers the volatility of a portfolio.

Analysts use the beta and other statistics to measure and describe the risk and return trade-off in a given portfolio. Such statistical analysis also can help an investor review and revise a portfolio to match his or her personal priorities and risk comfort level.

Next up: Another issue related to gauging the risk vs. return relationship is diversification.