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STABILITY
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Given the choice between steady-as-she-goes performance in a fund and volatile swings, investors are often better o with stability After all, you never know when you ll need to sell your shares If it happens that you must redeem your investment at an inopportune moment, things could work out poorly in a volatile fund Here is an illustration of the bene ts of stable performance Take two funds with average annual returns of 10 percent Fund X is consistent, with gains of 8 percent in the rst year, 10 percent in the second, and 12 percent in the third If you were to invest $10,000 in this fund, you d have $13,300 by the end of Year One The math works like this:
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Year One $10;000 0:08 $800 $800 original $10;000 $10;800 Year Two $10;800 0:10 $1;080 $1;080 original $10;800 $11;880 Year Three $11;880 0:12 $1;425:60 $1;425:60 original $11;880 $13;305:60
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Now let s look at Fund Y, also with average annual returns of 10 percent But Fund Y achieves that average by losing 20 percent in Year One, gaining 10 percent in Year Two, and gaining 40 percent in Year Three If you invested the same $10,000 in Fund Y, you d have only $12,320 by the end of Year Three That s right you d earn less than in Fund X, even though both had the same average annual returns Here s how the math works:
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PART 3 Selecting Your Assets
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What this shows is that by betting on steady, consistent growth, you can actually do better than by gambling on volatility This is because one terrible year in the market could set your portfolio back for years STANDARD DEVIATION One way investors can judge the steadiness of their funds is to look at the so-called standard deviation of those portfolios As you ll recall, we mentioned this term in 3 Standard deviation, in this setting, measures a fund s volatility relative to its average performance in a set period of time The lower the standard deviation, the less volatile a fund is considered to be, since it deviates less from its average performance than does a high standard deviation fund Every fund s standard deviation is listed by Morningstar What an investor can do, then, after screening for other characteristics, is to check if their fund s standard deviation is in line with or better still, lower than its category peers (Figure 13-13)
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Beta
Another way to gauge the relative volatility of a fund is to consider whether it uctuates more or less than the broad stock market As we discussed earlier
Fig 13-13 Average Standard Deviation among Fund Categories*
Type of Fund Domestic stock funds International stock funds Large-cap growth funds Large-cap value funds Large-cap blend funds Mid-cap growth funds Mid-cap value funds Mid-cap blend funds Small-cap growth funds Small-cap value funds Small-cap blend funds S&P 500
*Data as of March 31, 2004 Source: Morningstar
5-Year Standard Deviation* 2034 2144 2111 1685 1718 2917 1842 2056 3206 2015 2286 1693
Mutual Fund Selection
Average Standard Deviation among Fund Categories*
Fig 13-14
Type of Fund Domestic stock funds International stock funds Large-cap growth funds Large-cap value funds Large-cap blend funds Mid-cap growth funds Mid-cap value funds Mid-cap blend funds Small-cap growth funds Small-cap value funds Small-cap blend funds S&P 500
*Data as of March 31, 2004 Source: Morningstar
Beta / S&P 500* 093 086 105 091 095 109 084 094 112 083 092 100
in the book, a beta measure of 1 indicates that the fund will likely move in lockstep with the S&P 500 This explains why the Vanguard 500 fund, which mirrors the S&P, has a beta of exactly 1 On the other hand, a fund with a beta of greater than 1 is likely to move higher than the market when the S&P is up, but lose more than the market when the S&P falls Conversely, a fund with a beta of less than 1 is likely to lose less than the market when the S&P is down, and gain less when the S&P rises Ideally, it would be great to focus on funds with betas of less than 1 But because certain asset classes are just naturally more volatile than the S&P (particularly smaller stocks and growth stocks), it s important to weigh your fund s volatility relative to its peers Figure 13-14 lists the average betas for various fund categories Like standard deviation, beta gures are also available through various nancial Web sites, including Morningstar
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