…is simply false. Again, there is no free lunch, and investors in the funds that invested with Madoff are now paying a very high price for their ignorance.

How to Know Your Risk

One of the ways I assess risk, besides the Greek alphabet soup of betas and standard deviations and relative volatility measures, is something I believe is much more practical, and which speaks plainly to you and me when we talk about portfolio risk: Maximum Cumulative Loss, or MCL.

Maximum cumulative loss is akin to a "drawdown," something commodity traders have used to measure risk for decades. It looks at how much you actually lost, rather than assigning some Greek letter or mathematical factor to your holdings. It's one thing to say a fund has a beta of 1.35, which means it can move 35% more than the market in either direction. But it's quite another to say, for instance, that the worst loss suffered by a shareholder in that fund was 35%. You tell me which one makes more sense to you. (Learn more here.)

In any case, I measure MCL on a monthly basis, using month-end performance and pricing. For example, take Windsor II (VWNFX). The fund's shareholders took a 28.2% hit during the 2000 to 2002 bear market, but in the current market it has dropped 43.8% from its high, through November.

Knowing one particular fund's MCL is helpful, but being able to put them all together — with the underlying data — to measure portfolio risk is even more useful. I have built a proprietary risk calculator that we use at Adviser Investments, my portfolio management company, that I use for assessing portfolio risk when combining various Vanguard funds into one portfolio.

The calculator measures maximum losses as well as worst-case one-year, three-year and five-year returns on a rolling basis. As is often said in the investment business, historical performance is no guarantee of future performance. But when it comes to measuring risk, I can't think of a better way to do so than to use historical periods to get a sense of how a fund or portfolio of funds might perform when the storm winds are blowing.

Members who read Dan Wiener's Independent Adviser for Vanguard Investors know how much he despises risk. He goes to extraordinary measures to make sure your Vanguard risk is prudent and as small as possible. And, of course, he provides updated year-end MCLs and graphs for every Vanguard fund in the 2009 Independent Guide to the Vanguard Funds. If you haven't yet reserved your copy, sign up for Independent Adviser today and receive your copy absolutely FREE. Click here now to learn more about this special offer.