Over the last three decades, the number of persons invested in stock and bond mutual funds has increased significantly due to the advent and popularity of IRAs and 401(k) plans. As of 2008, United States residents alone held $14 trillion in mutual fund accounts. Whether mutual funds are used as vehicles for current investment returns or retirement savings, this article offers three specific investment tips for mutual fund holders.
Do Not Always Chase Winners or Shun Losers
Such anecdotes seem commonplace-at some social gathering, a financial dilettante boasts that he is invested in the year-to-date overachiever among mutual funds-up in excess of 30 percent. By comparison, you are currently down 3% year-to-date in your large capitalization, growth and income fund. This does not mean that you should hotfoot home, divest, and follow the investment course of the party braggart. After researching the outperforming fund, you may discover that it is concentrated in one particular sector or something as obscure as micro-capitalization stocks in a developing nation. It is also likely that you will determine that the fund has been in existence for a short period of time, maybe only one year, with no historical track record. In short, there is not enough statistical data to justify investing in the year-to-date outperforming fund. By contrast, while reappraising your decision, you are reminded of why you initially invested in your mutual fund–over the last 5 years it has an annualized return of 13%, outperforming the long-term, average return of the S&P 500 index.
The Coefficient of Variation
Many investors abhor volatility. Manic fluctuations in a mutual fund’s performance can be anxiety-inducing. The Coefficient of Variation (CV), is a very simple, yet useful, statistical formula that can measure the relative volatility of mutual fund returns. The formula is defined as the standard deviation of data divided by its average. A small CV statistic demonstrates steady returns. A large CV statistic indicates more volatile returns.
For the sake of simplicity, consider the annual, 5-year returns of two mutual funds–Fund (A) and Fund (B). Fund (A) has annual returns of 14%, 15%, -2%, -4% and 9%. Comparatively, Fund (B) has annual returns of 22%, 18%, -16%, -15%, and 26%. When comparing Fund (A) and Fund (B) at the most basic statistical level, Fund (A) has an average annual return of 6.4%, while Fund (B) has an average annual return of 7%. This statistic, however, is not dispositive of relative performance. If $10,000 had been invested in each fund at the beginning of year 1, the overall 5-year return for Fund (A) is 34.44% and only 29.51% for Fund (B). This statistical anomaly exists because Fund (B) has a much greater standard deviation than Fund (A). The standard deviation for Fund (B) is 18.55% and the standard deviation for Fund (A) is just 7.96%. Consequently, the CV for Fund (B) is 2.65 and 1.24 for Fund (A)–Fund (B) was twice as volatile as Fund (A) over the 5-year period. In sum, then, Fund (A) not only outperformed Fund (B) over the 5-year period, but it was far less volatile.
Diversification of Mutual Funds
Diversification is a risk management technique to limit downside exposure in an investment portfolio. Its idiomatic expression is: “Don’t put all of your eggs in one basket”. By definition, stock mutual funds invest in various stocks and are largely diversified against single-stock risk. Many investors falsely believe, however, that if they are invested in a stock mutual fund, they are adequately diversified-the concept of diversification is slightly more complex.
There are two types of diversification-horizontal and vertical. A stock mutual fund investor is horizontally diversified if (s)he owns mutual funds invested in a mix of growth, value, large capitalization, midsized capitalization, small capitalization, domestic and international stocks. Similarly, a bond mutual fund investor is horizontally diversified if (s)he owns a combination of federal, municipal, high-end, and corporate bond funds. Comparatively, a mutual fund investor is vertically diversified if (s)he owns stock mutual funds, bond mutual funds, money market funds and certificates of deposit.
Although no investor has control over the particular rate of return (s)he will receive from investments, Nobel Prize winner, Harry Markowitz, has called diversification the only “free lunch” in investing. That is, diversification is something that interested investors can often implement on their own without paying a fee to Wall Street.
Annual Retirement Assets, Investment Company Institute
Markowitz, H.M., Portfolio Selection, The Journal of Finance 7(1)