FROM VANGUARD WEB PAGE

 Summer 1999 Overview

Risk Measures Can Help You Evaluate a Fund

During the past five years, the Wilshire 5000 Equity Index a  benchmark for the entire U.S. stock market recorded a total return of nearly 200%, tripling the  value of each dollar invested in such a basket of stocks.

In an extraordinary bull market like this, dazzling rewards can,  however, obscure the other side of investing: risk. During the past year though, risk made some  notable appearances: Stock prices plummeted in summer 1998, and bond prices fell sharply this  spring as interest rates rose.

You can't escape risk, but you can temper it through diversification  and portfolio balance. You can also measure it.

Risk measures can help you to decide whether a mutual fund is  appropriate for your temperament, time horizon, and investment goals. This article  examines several risk measures, including two -- beta and R-squared -- that our Funds Directory provides for individual Vanguard stock funds. The jargon of risk measurement may  be forbidding, but the concepts are simple.

Beta. Beta measures whether a fund tends to rise and fall as much as  the market. For stock funds, beta is generally measured relative to the S&Pr 500 Index; for  most bond funds, the benchmark is the Lehman Brothersr Aggregate Bond Index. By  definition, the beta of the market index is 1.00. A fund with a beta of 1.50, for example, is  significantly more volatile than its benchmark. It would tend to gain 1.5% for every 1% rise in the  market, and lose 1.5% for every 1% decline in the market. On the other hand, a fund with a beta  of 0.50 is notably less volatile than its benchmark.

R-squared. R-squared captures the degree to which fund returns go up  and down at the same time as the market. An R-squared of 0 means that a fund's  returns have no correlation with a benchmark's fluctuations; an R-squared of 1.00 indicates that  a fund's returns are completely in sync_up and down_with the benchmark. An R-squared of  less than 0.70 suggests a low correlation between a fund and its benchmark index.  R-squared also provides a context for beta. Simply put, beta may not  mean much if the R-squared is low. For example, Vanguard Gold and Precious Metals Fund  has a relatively low beta of 0.79, but the fund is hardly a low-risk investment. The  fund's R-squared of 0.14 reveals that its returns are weakly correlated with those of the S&P  500 Index, so its beta versus a broad index tells you little about its volatility.

Standard deviation. This statistic compares a fund not with a  benchmark, but with its own past record. Standard deviation is the degree to which a fund's  returns have fluctuated above or below its mean, or average, return over the previous 36 months.  Suppose, for example, that Fund A posts annual returns of -5%, +10%, and +25%. Over the  three years, it earns an average annual return of +10%, with a standard deviation of 15. Fund  B returns +5%, +10%, and +15%. It too earns an average return of +10%, but its standard  deviation is just 5. So, Fund A has been three times as volatile as Fund B.

No One Measure Tells All

All risk measures have limitations. First, they're based on past  performance. Jeffrey S. Molitor, Vanguard Principal and Director of Portfolio Review, explains that  "there is some stability in risk measures over time, but funds can change their character. The  past three years may not be indicative of the next three."

Second, no single measure paints a complete picture of risk. Mr.  Molitor cautions that "R-squared and beta allow you to evaluate funds against a common  benchmark, but they should not be used to the exclusion of other measures. Investors should consider qualitative risk factors such as investment style and portfolio concentration."

Finally, statistics don't capture the potential consequence of risk:  loss. To assess that potential, review a fund's annual returns, preferably for a long  period. In 1994, Vanguard Gold and Precious Metals Fund gained +89.2%. A year later, it declined  -19.2%. These figures make clear something the risk measures only suggest: Vanguard Gold  and Precious Metals Fund can be extremely volatile, and like all stock funds, it can lose  money.