Even when Beta and standard deviation are applied to real-time transparent portfolios, they have weaknesses as risk-monitoring tools. For starters, Beta doesn't really assess portfolio risk. It measures the relative volatility of an investment or portfolio compared to a benchmark, such as the S&P 500 Index. Beta can be relatively low in very risky investments that don't track the S&P 500 – such as emerging market equities. So, it's neither accurate nor helpful to tell clients that low-Beta investments are always low in risk.

Standard deviation is a statistical tool that was borrowed by the mathematicians who invented Modern Portfolio Theory (MPT) to explain characteristics that financial markets have in common with random events. For financial analysis purposes, the most common way that standard deviation is calculated is to annualize a set of monthly investment returns from a single investment (or benchmark) over several years. For example, a standard deviation calculation made over a five-year period often evaluates 60 equally-weighted pieces of data (5 years x 12 months). At each monthly interval, the calculation changes as follows: The oldest of those 60 pieces is discarded and replaced by one new piece. The other 59 pieces stay the same. This makes standard deviation a sluggish statistic, always heavily weighted with old data.

If the market suddenly becomes more overvalued and volatile, as occurred near the height of the 1999-early 2000 bull market, standard deviation doesn't detect it, because the calculation only considers one investment at a time and doesn't overweight recent data. It also makes a statistical assumption that investment markets often defy – namely, volatility is symmetrical around a mean. In a deep bear market, investments usually fall farther and faster than they rise in bull markets. Any "momentum" that exists in the markets, the tendency for trends to continue, is virtually ignored by standard deviation.

The most questionable and potentially deceptive applications of standard deviation are appearing in the objectives of some new types of investment products, including fund-of-funds and "lifestyle" or asset allocation portfolios. Typically, these solutions blend together several managers or funds to pursue superior risk-adjusted performance versus a benchmark over time. They may state that they will measure risk by applying standard deviation, but they rarely disclose in advance the specific calculation method to be applied, among several commonly used. This leaves the door ajar to numbers-juggling down the road. In evaluating any such portfolio, quiz your wholesalers to determine how standard deviation and risk-adjusted return will be measured. Ideally, these calculations should be performed and reported by an independent third-party – not the investment manager or product sponsor.

In summary, the acid-test for risk-management came during late 1999 and early 2000, when many investors became over-concentrated in large-cap growth stocks that grew riskier by the day. Both Beta and standard deviation flunked that test with flying colors, as they are likely to flunk when the next big test comes. Today, for example, U.S. government bonds are probably riskier than they were a few years ago. But these metrics don't show it.

Risk = Probability of Loss in Real Time

If Beta and standard deviation aren't the answers for professional risk management, what is?

An outstanding book on financial market risk was written by Peter L. Bernstein and titled Against the Gods: The Remarkable Story of Risk. The author's thesis is that the science of risk-management has always been about assessing the probability of future loss in real time.

For example, just before you roll a pair of dice, what are the odds of throwing "snake eyes?" The answer is 1 chance in 36. But what are the odds of rolling the equivalent of "snake eyes" with an investment portfolio? Few financial advisors currently help clients assess risk in this way, even though the analytical tools to perform such analysis are emerging.

For some time, institutional bond traders have applied a risk metric known as "value-at-risk (VAR)" to define the probability of loss. For a given "confidence level," such as 95% probability, VAR measures the maximum amount of loss an investor should be prepared to absorb. The beauty of VAR is that it can change daily, or even hourly, with financial markets. For example, a trader can go to bed knowing that portfolio VAR falls within risk guidelines, yet wake up to find that the guidelines have been exceeded by overnight market changes. VAR can trigger risk-adjusting trades in real time – a service that can be as valuable to individual investors as to institutions.

VAR is too complex for most individual investors to understand, which makes it difficult for retail financial advisors to apply. But several years ago, one pioneering firm broke through the complexity barrier to implement a VAR-like concept in individual portfolios, in a way that most investors can understand. The firm is RiskMetrics Group, and the tool they developed is a proprietary metric called "Xloss." You can read more about it on their Website here:

• http://www.riskgrades.com/retail/rghelp/index.cgi?href=index.html

Xloss looks at a portfolio in real time, daily or even hourly, and assesses the amount of money (in dollars) that a portfolio can be expected to lose, on average, in the worst 5% of trading days. It calculates this amount by looking backward at the same investments' actual performance over the previous year and averaging losses on the "worst case" trading days. This makes Xloss a more sensitive indicator of current portfolio risk than standard deviation. For example, during 1999 and early 2000, Xloss values for Nasdaq stocks and large-cap growth portfolios increased sharply.

Xloss also works well in communicating risk concepts to clients. For example, would it cause the client sleepless nights to experience several daily losses of Xloss size? By tracking changes in portfolio Xloss on a weekly or monthly basis, the advisor can demonstrate that risk-monitoring services are continuous, objective and actionable – which helps to justify ongoing asset-based fees. Separate account managers can be monitored and even replaced for exceeding Xloss thresholds.

RiskMetrics Group has licensed Xloss (along with its other proprietary metrics) to several investment firms through application service provider (ASP) technology linked to separate accounts and brokerage accounts, in real time. Other analytical firms have also begun developing competitive probability-based risk metrics modeled after those of RiskMetrics Group.

Measuring the Probability of Beating a Benchmark

Over the past 3-4 years, a major change has occurred in financial markets that some investment management firms still don't comprehend, because they continue to write legal disclaimers stating that "it is not possible to invest directly in a benchmark."

Through exchange-traded funds (ETF), it has become possible to invest in passive solutions that track benchmarks (single-index or custom-blended) within two or three decimal points of 100%. Since more investors are accepting the convenience and cost-efficiency of benchmark-tracking, it makes sense that a new type of risk metric will emerge to help them assess the probability of rolling "snake-eyes" in an actively managed portfolio-i.e., failing to beat their benchmark on either an absolute or risk-adjusted basis.

Suppose you had the analytical ability to determine that a given lifestyle or asset allocation portfolio has an 85% probability of under-performing its benchmark over the next two years. Would you recommend it to your clients?

Although this ability does not yet exist, it is on the way. Two main variables determine the probability of an active manager's success in beating benchmarks: total costs and the probability that the active management strategy will be successful. Total costs can be determined to a degree, but there is not yet a standard method for evaluating the probability of active management success. However, using other RiskMetrics Group metrics, it is possible to estimate the degree to which an investment strategy is trying to add meaningful diversification or active management value.

One such metric, "Diversification Benefit," compares the risk of a portfolio with the weighted average risk of each component, considered separately. An efficient portfolio should have lower total risk than the sum of its parts. But what if the portfolio owns so many securities, or blends so many managers, that it becomes the equivalent of an "inadvertent index fund" with high fees? In that case, it will have produced "superfluous diversification" that doesn't add active management value and stands little chance of outperforming a benchmark (absolute or risk-adjusted) over time, after costs. The Diversification Benefit metric can be used to evaluate and monitor not only real diversification but also superfluous diversification. Until a better metric comes along, it is among the better tools for helping clients select actively-managed, well diversified portfolios with a good chance of avoiding "snake eyes."

How to Lay the Groundwork for Real Time Risk-Monitoring

Even if you can't apply real time risk metrics to client portfolios now, you can start laying the groundwork in two ways:

• Real time risk metrics can only measure what they can see. So help your clients take advantage of the transparency of separate accounts, fee-based brokerage accounts, folios and multiple-strategy accounts. Accurate and timely risk-monitoring may become one of the most valuable benefits of holding individual securities, compared to opaque funds.
• Accept the fact that part of your job is to help clients assess: 1) the probability of future portfolio loss; and also 2) the chance of failing to beat benchmarks on either an absolute or risk-adjusted basis. Help clients use risk metrics to look forward at dynamic markets – not backwards at ancient history.

Real time risk-monitoring is a valuable service for which you can earn fees on a continuing basis. Start educating your clients about this service now.