Say your tech fund finished down 40% last year? Feeling a little jealous of all those folks with dull investments that didn't tank? Well, buck up, because over the long term, there's a decent chance you're going to make more money.
Funds that post big returns in good years but also lose scads of money in down years still tend to do better over time than funds that post slow, steady returns without ever losing much. The capacity to move a lot in both directions might appear to have "erased the ups in many cases," says Raamy Shaalan, senior mutual funds analyst at
. But in practice, he says, "it means the funds tend to have higher upside. And if they have higher upside, they will end up with higher returns."
In the long-term, the tendency of volatile investments to outperform their more stable counterparts can be examined through a measure of statistical risk called
standard deviation. Standard deviation measures the range in a fund's performance, usually over a three-year period. A high standard deviation indicates a fund's performance has fluctuated a lot from year to year.
A low standard deviation reflects little volatility in returns. Some bond funds, for example, claim standard deviations of less than a point.
To take an all-too-familiar example, consider the volatile
Nasdaq Composite Index
, which has a standard deviation of 39.21. According to Wiesenberger, if you'd invested $10,000 in the Nasdaq at the beginning of 1999, you'd have watched that investment surge to $18,559. In the next year, your holdings would have gotten creamed. Still, at the end of 2000 you'd be left with $11,267.
By comparison, the
standard deviation, 18.18, is only half that of the Nasdaq, and its rewards are correspondingly less. If you'd invested $10,000 in the S&P 500 at the beginning of '99, you'd have only $12,105 at the end of the year. At the end of 2000, your total would be $11,003 -- still a lower payoff than the Nasdaq provided.
The tendency for volatile investments to best those with steadier returns is even more pronounced over time. When we compared volatile funds with less volatile funds over a decade, those that tended to see big performance swings emerged the clear winners. They made roughly twice as much money over a decade.
The charts below contain domestic equity funds with at least a 10-year record (and at least 90% of their holdings in stocks). We compared those with the highest standard deviations within that category, seen in the first chart below, to those with the lowest standard deviations, contained in the second chart.
The results: All but one of those in the high standard deviation group beat the S&P 500. Given an initial investment of $10,000, 10 years later the average fund in this group finished with $67,074.
Meanwhile, none of the funds with more stable returns managed to beat the market. The average fund in this group turned a $10,000 investment into $34,397 -- nothing to sneeze at, but still only about half the gain of its riskier counterparts.
In fairness, a couple of factors complicate that scenario a little. For one thing, the last decade has been atypical, with the market enjoying outsize gains relative to losses. So the degree of outperformance by more volatile funds is probably exaggerated. Also, within the same period, funds with high standard deviations have tended to be those that owned growth stocks, which saw especially big fluctuations in value. The better performance of growth-oriented funds may partly reflect the fact that aggressive growth, until recently, was in favor.
"That's probably true," acknowledges Shaalan, "but generally speaking, higher volatility means the potential for higher rewards. In the long term, regardless of risk, the markets have always moved higher, assuming long term is even 10 years." All this goes back to the basic investing premise, as Shaalan points out, that higher risk often leads to higher reward.
That's not to say, of course, that funds with high standard deviations are necessarily good investments. The mere fact that a fund has a high standard deviation is certainly not reason to buy into it. If anything, you might want to check it out more carefully, because risky doesn't imply good. Plenty of funds with high standard deviations -- like gold funds -- have abysmal performances.
And if you do buy into riskier funds, you want to be sure you're prepared to hold on for a long time -- as long as 10 or 20 years -- to wring the upside out of performance volatility. This flies in the face with the tendency of many individual investors who cycle in and out of riskier fund fare according to what's in vogue.
So think of it this way: a higher standard deviation doesn't mean a fund will outperform. But funds that outperform tend to be those with higher standard deviations.
Of course, it's crucial to diversify your holdings across lots of different kinds of stocks, for a mix of value and growth. But after a horrendous year, it may help to remember that big losses for growth funds -- in some cases -- are just the flipside of big gains. They may not necessarily mean you made a bad investment. And if you have the requisite patience and a long enough holding period, you may end up being well rewarded for your risk.