While reading your favorite financial magazine (presumably this one), you note that the hot Russia fund into which you sank $10,000 six months ago gained 35% over the past year.
You smugly compliment yourself for your investing brilliance. But a few days later, your fund statement arrives and you're shocked to discover that your stake is now worth only $9,000. What happened? you wonder.
What happened in this hypothetical, but far from far-fetched, example is that the fund achieved all of its past-year's gains before you bought it and sank after you invested. One plausible scenario: The fund may have rocketed 50% in the first six months of this hypothetical 12-month period, lured you in, then lost 10% the next six months -- hence, a one-year return of 35% but a 10% loss for you.
The difference between a fund's published returns and what investors actually earn is the subject of important new data from Morningstar. The fund rater looks at dollar-weighted returns, or how much money the average dollar invested in a fund earns over time. These "investor returns" take into account a common error that too many of us make: buying funds when they're hot and selling them when performance drags.
Morningstar's figures underscore the emotional dangers of investing in high-octane funds. Over the past ten years to November 1, investors in the most volatile 25% of mutual funds earned, on average, only two-thirds of the funds' average reported total returns (see the table for some specific cases). "Volatile funds inspire fear and greed and make people handle their money poorly," says Russ Kinnel, Morningstar's director of fund research. "They buy after the fund has made a lot of money and sell after it has lost money."
In contrast, investors in more-stable funds -- value-oriented and low-turnover funds often fit the bill -- earned virtually the same amount as their funds' stated returns over long periods. "The more boring funds rarely have those emotional tripwires," says Kinnel. "Investors tend not to get thrown for a loop with stodgy funds."
The message is clear: Pay attention to volatility, a good proxy for risk. Before you buy a volatile fund, make sure you have the constitution to withstand the inevitable spills. Better yet, make sure those rockets are part of a well-diversified portfolio. That way, your investment program isn't at the mercy of one fund's possible collapse.
Returns: You vs. the fund
Investor earnings are often far less than funds' reported gains, particularly with volatile funds.
Data through September 30. Source: Morningstar
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