Volatility in a mutual fund lowers gains

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Reid Johnson

Mutual funds are the cornerstone of many investors’ portfolios. With thousands of mutual funds in the U.S. alone, choosing the right one for your retirement plan can be complicated.

Consider this real-life example (names have been changed, of course, to protect confidentiality): Bob and Sally walked into my office looking for advice about mutual funds. They had narrowed their choices to two funds, but that’s when it got tricky.

Each fund had the exact same average annual return over the past five years: 5.53 percent. They wondered, “Which one do we choose?”

You would think two funds with the same average annual return would produce the same amount of money, right?

Let’s take a closer look. The chart to the left shows a side-by-side comparison of the two funds’ rates of return.

Over the past five years, the holdings in Fund A produced big returns (nearly twice as big as Fund B’s gains) four out of five years with one bad year. The five-year average annual return was 5.53 percent.

The five-year average annual return of Fund B was also 5.53 percent. It posted lower returns than Fund A four out of five years and recorded a smaller loss in Year 2.

Okay, so which one should Bob and Sally choose?

Look at the ups and downs

The answer is Fund B. Emphatically. It’s not even close, and here’s why:

With $500,000 invested in each fund, and with an average return of 5.53 percent a year, Fund A earned $69,477.

Mutual Fund B earned $143,357. That’s an eye-popping difference of $73,880!

What’s going on here? Volatility. It’s all about the volatility within a mutual fund. The fund with the least amount of volatility produced more cash over five years.

People generally think rate of return is the most important factor to a fund’s success. But the truth is volatility is a bigger factor.

For example, if a mutual fund drops 25 percent one year, then you need a 33 percent increase just to break even. Bigger losses require even bigger gains: A 50 percent drop needs a 100 percent increase to get back to even.

Bob and Sally’s example serves as an important heads-up if you’re buying in the current market, now at historic highs, because volatility in a dramatic downturn could translate into significantly less money for your portfolio over a period of years.

This lesson raises a key question: Why do we accept higher risk, and volatility, in our personal portfolios?

It goes back to the basic investment principle that we’re all led to believe: take the higher return to earn more money; accept more risk for more return.

But that’s not necessarily the right choice. Mutual funds experiencing big fluctuations like the one above — Fund A with a 37 percent drop in one year — are detrimental to your portfolio. That’s an eye-opening lesson.

Reducing volatility

Apply the same principle to your own investment portfolio. Can you reduce volatility in your portfolio through smart asset allocation?

Make sure your portfolio is not weighted too heavily with one type of fund. That strategy will better protect you from big market downturns.

You’d be surprised by the number of investors walking into my office who firmly believe their portfolio has low volatility like our Fund B, but a closer look reveals they actually own something closer to Fund A. About 70 percent discover they have too much volatility.

One other thing to consider: Many people buy passively managed mutual funds because they charge lower fees. Low fees mean low turnover in the fund; managers are not trading much.

That strategy is great for a rising market, but in a year like 2016 with lots of ups and downs, you want your portfolio to have more flexibility so you can adjust them during market fluctuations.

Giving managers the option to grab discounts, or sell poor performers, could reduce volatility and put your portfolio in a better position over the long term. Not making changes can cost you.

Now you’re better prepared to put together a winning retirement portfolio. You understand it’s more important to evaluate the volatility in a fund rather than its average rate of return. That’s a valuable lesson whether you’re in your 40s or 50s, or nearing retirement like Bob and Sally.

Talk to an investment adviser about performing a full analysis on your mutual funds. It will reveal whether volatility in your high-performing mutual fund is actually killing your portfolio, and if you need to adjust your game plan.

All contents © 2016 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.