When building a 401k portfolio, many people simply look at a fund’s performance without considering the risk of the investment. Fund performance should not be the only tool used in selecting mutual funds for your 401k. Another analytical tool that should be used is standard deviation.
Standard deviation measures the risk of an investment. For example, the Growth Fund of America has a 5 year standard deviation of 16.45 and a 5-year average annual return of 4.76. This means that the portfolio historically has moved 16.45% above 4.76 and 16.45% below 4.76 over a 5 year period. This gives you an idea of your downside risk and upside potential. In comparison, the PIMCO bond fund has a 5 year standard deviation of 4.25 and a 5 year average return of 7.17. Adding these two funds to a portfolio at a 50/50 ratio would give the portfolio a 5 year standard deviation and rate of return of 10.35 and 5.96, respectively. In this scenario, we just lowered the risk of the overall sample portfolio by adding bonds. You can use Morningstar.com, a free and independent research firm, to find the standard deviation and rate of return of each fund within our 401k plan. As you will see, some funds in our 401k plan, while they may be in the same asset class, do not have the same risk.