FOOL ON THE HILL
You don't have to agree with everything professionals say about diversification and volatility to see that these basic concepts are valuable for investors shopping for mutual funds. A fund that achieves high returns over a two- or three-year period may have done so merely by catching the latest investing wave, a very risky and short-sighted strategy.
 |
|
|||||||
|
||||||||
|
||||||||
By
Everyone knows risk and reward are closely linked, and that investors cannot expect higher returns without additional risk. But that doesn't mean we use this information the right way. What it means -- and this is the point driven home in Peter Bernstein's books Capital Ideas and Against the Gods -- is that a portfolio that achieves superior returns isn't necessarily worth a darn if it's taking on too much risk to do so. For investors, that means we can't just tally returns to determine whether a mutual fund is putting up impressive results: Buying a mutual fund based solely on returns is a little like shopping for a car without looking at the price tag -- just go out and buy what looks good. Instead, investors need to look at the precipice over which the portfolio dangles. The Janus family of mutual funds, for example, which piled up huge gains in the bull market of the late 1990s, saw the value of its funds plunge sharply when the technology market soured. We have to put the returns earned by these portfolios in perspective by considering the risk taken investing in groups of high-priced, high-technology stocks. Risk is typically viewed as price volatility: The more a stock price fluctuates relative to an index such as the S&P 500, the riskier it is. Risky funds are considered those with a high percentage of assets in stocks rather than bonds, and with poor diversification in terms of number of stocks or the close relationships that exist between those stocks. A mutual fund that looks like the Nasdaq 100 isn't well diversified and, therefore, will be very volatile. Of course, there's a lot of disagreement about how to define and how to quantify risk. Many view volatility as too narrow a view to be of any real use to investors, and diversification can be taken too far. The average U.S. mutual fund owns more than 100 stocks, yet a basket of 15 to 30 can provide all the diversification the average investor needs if the portfolio is wisely constructed. I don't agree with everything professionals say about diversification and volatility, but these basic concepts are valuable for investors shopping for mutual funds. A fund that achieves high returns over a two- or three-year period may have done so merely by catching the latest investing wave, a very risky and short-sighted strategy. If the mutual fund owns a basket of high-priced technology companies, or a group of stocks centered around the latest investing or business concept, it isn't diversified and it isn't protecting investors against the inevitable downside. It doesn't require skill to produce market-beating results for one year, just luck, which comes along more often than the average investor realizes. Any investor in such a fund should go in with their eyes wide open. My investing philosophy starts with index funds, which provide diversification and offer low transaction costs. At the same time, I plan to regularly invest in a focused portfolio of stocks of my own choosing, from perhaps five or six to as many as ten or twelve. (Some call this the "Index Plus a Few" strategy. If you're building your own portfolio, check out our Choosing Stocks With The Motley Fool online seminar.) With these stocks, I won't be concerned about diversification, correlation, or volatility, which I've already addressed with the index fund. I'll merely invest in a few of the best companies I can find available at deep discounts to what I consider their intrinsic value. I'll rely on this margin of safety approach to iron out the risks of investing in such a small basket of companies. I have no illusions about the riskiness of this tack, or the difficulty of beating the market. It is very risky, and beating the market is difficult. This is simply my own investing experiment. Have a great day. Richard McCaffery wants to know when "Rock 'n' Soul: Part 2" is coming out. The Motley Fool is investors writing for investors.
RSS Headlines
Fool UK
