Editor's note: This column first appeared in The Save Safe Plan on Friday, April 4. For more information on The Save Safe Plan, click here
When the market was rocketing in the late 1990s, plenty of people failed to recognize how much risk they were taking on in the mutual funds they owned. But three years into a bear market, that downside is now very real. That's probably the first thing you think about before buying a fund nowadays: How much money can I lose?
A fund's prospectus should spell this out for you. Alas, these documents are filled with generic, watered-down descriptions of what could happen in the fund.
Fortunately, you don't have to buy a mutual fund and then lose 40% of your money to understand how risky that fund is. Looking at a fund's past volatility, short-term performance and portfolio composition are a few simple tests that gauge how hazardous a fund might be.
You can never know exactly how much a fund might make or lose in the future. But you can get a good idea if you should put your money in a fund or run in the other direction.
No one statistic will tell you everything you need to know about a fund's risk and its potential. But a fund's standard deviation is a good place to start. This number measures the range of a fund's performance around its average -- essentially, how wildly the returns will swing. The higher the standard deviation, the greater a fund's volatility.
Volatility isn't necessarily a bad thing. It's the chance that a fund will go up or down a lot. By trying to limit your downside, you might be limiting your upside as well. That's the trade-off.
Standard deviation by itself won't indicate whether a fund's risky. You must compare one fund's standard deviation with similar funds. For instance, to tell if one large-cap U.S. stock fund is more volatile than another, look at their standard deviations, which you can easily find on Morningstar's Web site. To find out how volatile a fund is in relation to the broad stock market, compare that number with the standard deviation on a broad stock market index fund, such as one that tracks the S&P 500 or the Wilshire 5000.
This statistic can be deceiving, however. A fund can have a low standard deviation if its performance has been consistently awful, which is why you'll also want to look at the fund's past record to see if its performance is solid.
You've probably been told over and over again that you shouldn't look at a fund's short-term performance. But as with all rules, there are exceptions. A fund's fluctuations in a day, week or month can give you some insight into how volatile it is. If the market climbs 2.5% in a day and a fund you own jumps 5%, that tells you something about the risks a manager is taking. That fund might be concentrated in a few stocks or in one sector. You should look for the same thing on the downside -- how much a fund will fall in a short span of time.
You can examine a fund's best and worst performance: How much did it rise in its best year? Or fall in its worst? How much did it plummet during its worst quarter? And how does that performance compare with its peers and the broad market? Then you have to ask yourself if you can live with those kinds of swings.
The type of stocks a fund buys will tell you a lot about the volatility of its performance. Value stocks, for example, tend to be more stable than growth stocks. Value stocks tend to be companies like
, which have established businesses with predictable earnings and revenue. With growth stocks, on the other hand, you're betting on the future prospects of these businesses. The growth and profit potential are enormous, but so is the possibility of failure. For example, the standard deviation on the average large value fund is lower than that for the average large growth fund.
When you're analyzing a fund, you should also inspect its sector allocation and the concentration in its top 10 holdings. If more than one-third of a fund's money is in its top 10 stocks, those are some big bets on just a few names.
Concentration by itself isn't a recipe for ruin. Again, it goes back to the type of stocks a fund is buying. A fund that's concentrated in tech stocks is probably going to be more treacherous than one focused on energy companies. And a fund can be diversified across different parts of the market and own only a few dozen stocks, like the
Marsico Focus fund.
Ultimately, if you want to avoid losing lots of money in the future, you should diversify across several different funds and asset classes. But remember that controlling your portfolio's downside means limiting its upside as well.
In keeping with TSC's editorial policy, Dagen McDowell doesn't own or short individual stocks, nor does she invest in hedge funds or other private investment partnerships. Dagen welcomes your questions and comments, and invites you to send them to
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