'Brutal' Losses Tarnish the Stock Fund Strategy

A drubbing isn't any less painful when it reaches historic proportions, as most fund investors can now tell you. Let's survey the situation and think about where to go from here.

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Even before the terrorist attacks on Sept. 11 sent battered stocks lower, this was already the worst year in recent memory for stock-fund investors. We've already pointed out that both bonds and three-month certificates of deposit are beating stocks over the past three years. Now let's get some perspective on the losses suffered by fund investors over the past 12 months:

• The average U.S. stock fund is down more than 25% after finishing only one of the past 10 years in the red -- a 1.1% dip in 1994.



• The average large-cap blend fund, a core holding in most portfolios, is down 31% -- the category's worst loss in more than 30 years.



• The $78.8 billion (FMAGX Quote)Fidelity Magellan fund, the nation's largest fund, has lost more than one-third of its value over the past year -- its worst fall since 1973.



• The average tech fund is down more than 70% over the same stretch after posting gains every year from 1985 through 1999.

The idea behind buying a stock mutual fund, rather than a stock, is that it gives you broad exposure to the market and a decent shot at its historical average of 11% annual gains without pegging your money to one company's fate. But the losses suffered over the past year by fund investors, even those who thought they'd dutifully diversified their portfolio, have been downright stocklike. So deep, in fact, that even investors who have been in funds for two, three or five years have been making less than 11% annually.

"It's been brutal," says Scott Cooley, a senior fund analyst with Chicago fund-tracker Morningstar. "Even when you look at five-year returns, there are only two in double digits and some that are very modest."

And those two categories, health care funds and financial services funds, are niche or sector-specific funds. The large-cap diversified funds that make up a bigger chunk of most investors' portfolios are averaging an annual return south of 8% over the past five years, according to Morningstar. The average large-cap growth and large-cap blend funds are actually averaging annual losses over the past three years.

The reason: Many funds made fat bets on the tech sector as it rocketed north from 1998 through early 2000. Investors' reluctance to diversify into broader index, bond or tech-light funds led to protracted losses after 1999's massive gains.

Tech Fever Breaking Top-selling funds in 1999 and 2000 bet on tech, but now they've fallen furthest
Fund Category	Tech-Stock Weighting	YTD Return	1-Year Return	3-Year Return
Technology	79%	-53.9%	-70.6%	1.6%
Large-Cap Growth	31	-35.9	-46.9	-1.5
Mid-Cap Growth	28	-36.6	-47.4	5
Small-Cap Growth	25	-28.8	-38.1	8
Avg. U.S. Stock Fund	22	-24.6	-28.4	3.3
Small-Cap Value	12	-11.5	-4.5	8
Large-Cap Value	11	-17.4	-13.2	2.4
Mid-Cap Value	9	-11.5	-4.5	8
Source: Morningstar. Returns through Sept. 20. Portfolio data as of most recent report.

After 1999, when the average tech fund gained 137% and the average growth fund bet more than 40% of its money on the sector, investors sank most of their money into tech- and tech-stuffed growth funds. Before last year, sector funds had never taken in more than 10% of the cash that flowed into stock funds in a given year. But last year a record $309 billion gushed into stock funds, more than 33% into tech and telecom sector funds. At the same time, bond funds were in net outflows for the second year in a row, according to the Investment Company Institute, the fund industry's largest trade group.

With so many of the nation's top-performing and top-selling funds making outsize bets on tech, even investors who thought they'd diversified their portfolio ended up with big losses. Consider the fate of an investor who split his portfolio evenly among the (JAVLX Quote)Janus Twenty, (FDEGX Quote)Fidelity Aggressive Growth, (PRSCX Quote)T. Rowe Price Science & Technology and (VFINX Quote)Vanguard 500 Index funds over the past five years. Each is big, popular and a household name in its category. Unfortunately, that combination added up to a portfolio with more than half its money in tech and telecommunications stocks.

Over the past 12 months this "popular portfolio" would have lost more than half its value, doubling the S&P 500's steep loss. It also trailed the benchmark over the past three and five years as well.

It Pays Not to Be Popular It made sense to own big, widely held funds, right?
	Popular Portfolio	S&P 500
1-Year Return	-54.2	-24.5%
3-Year Return	6.5	7.2
5-Year Return	10.4	13.3
Best Quarter	35.7	22.1
Worst Quarter	-30.3	-13.1
Source: Morningstar. Returns through Sept. 1. Popular portfolio: Janus Twenty, Vanguard 500 Index, Fidelity Aggressive Growth and T. Rowe Price Science & Technology.

How bad have things been for tech-heavy funds? Even if you'd invested $10,000 in the Fidelity Aggressive Growth fund on Jan. 1, 1999, prior to a 103% gain that year, you would've had only $7,550 at the start of this month.

So, the stock market, thought to be a cash machine in 1999, now seems like a money pit. What do we do now?

Given the severity of the losses we've seen and the paucity of redemptions from stock funds, it seems many investors are thinking one of two things: Either that stocks are down so far that we're due for a white-hot rally, or that long-term goals like retirement or saving for college are too far away to merit panicking now.

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As you probably imagine, the latter makes sense for most investors, but the former does not because none of us knows with any confidence where stock prices will be a week, month or year from now.

"We're getting to the point with the S&P 500 where you start to compare it with what happened in 1973 and 1974," says Cooley. "One lesson of that downturn was that there were some pretty rotten returns for large-cap stocks for several years after that."

If you've already got enough cash to cover three to six months' expenses in the bank for emergencies and you're investing money you won't need for 10 years, it's best to stick with old saws of mutual fund investing: Continue making monthly investments in a blend of cheap funds that give you broad exposure to the stock and bond markets. Fact is, if you stick with this kind of plan, using funds like Vanguard's (VTSMX Quote)Total Stock and (VBMFX Quote)Total Bond Market index funds, you don't need huge returns to save a hefty sum.

If you invest just $500 each month in a portfolio that averages a 7% annualized gain for 10 years, for instance, you'll end up with more than $86,000. If you're five years away from your goal, think about putting more money in bond funds and ratcheting down your stock exposure each year. As long as you're planning on a lower return, there's less chance you'll come up short.

If your goal is less than five years away, you might give serious thought to being a saver, not an investor.