Investing in Volatile Markets

Past performance is no guarantee of future results. In investment jargon, this saying is equivalent to Caveat Emptor—let the buyer beware.

How often have we all read these words and quickly dismissed them? It's frequently interpreted as an alarm to investors that funds with mountaintop performance today might be settling in the valley tomorrow. However, there's another angle on this axiom that most investors typically miss: funds in the valley today can climb to the mountaintop tomorrow.

If we see that an asset class (such as growth stocks) or a specific investment fund produced poor investment results over recent periods, do we dismiss these choices and look for more promising places to invest our savings?

An Elevator Ride Up Starts on a Lower Floor

Savvy investors know that the key to wealth accumulation through investing is to remember the maxim "buy low and sell high". And while most of us conceptually believe this maxim to be true, too often we are influenced by the twin evils that peril prudent investment decisions known as fear and greed. During the late 1990s, the evil of greed influenced too many professional and unsophisticated investors who chased after promises of riches by investing in certain high-flying stocks that were registering "too good to be true". Hard earned savings flowed at unprecedented levels to highly speculative investments only to vanish when the bubble burst.

Now, after two and a half years of the second worst bear market in U.S. history, the evil of fear dominates investor emotions. As a result, we have seen record withdrawals from stock mutual funds and record deposits into bond mutual funds. Why?

Those with savings to invest now see advertisements touting bond fund performance results that, in many cases, approach an average of 10% each year over the past three years. So, one might conclude that bonds represent a better investment opportunity given recent performance especially when compared to the investment performance of the stock market.

Make Sure You Understand a Bond's Actual Return

It's worthwhile to explore what drives bond returns and the likelihood that future bond market performance will resemble recent results. The best place to start in trying to gauge the future performance of a bond fund is to look at the fund's current yield, which helps determine a portion of the actual rate of return on your investment.

Of course, there are many more factors that affect bond fund performance. But, the current yield is a good place to start. Presently, the current yield for the most popular bond index (Lehman Aggregate Bond Index) is about 4%.

A Common Misconception about Bond Funds

Many investors mistakenly believe that a bond fund cannot go down in value. This is not true! Two major factors also influence a bond fund's performance besides current yield:

1. credit rating and
2. changes in the general level of interest rates.

The concept of credit rating is easy to understand. Economic conditions and other factors improve or impair the credit rating of bonds held in a bond fund. When a bond receives a downgrade in its credit rating, its price typically declines. The names Enron and WorldCom should immediately invoke an understanding of a negative credit event.

Understanding the influence of changes in interest rates, however, is a bit more complicated. As you may be aware, the Federal Reserve and Federal Reserve Chief Alan Greenspan exercise a great deal of responsibility in maintaining the stability of the nation's economy by establishing interest rates. When the economy weakened, fueled by the devastation of 9/11, Mr. Greenspan engineered a reduction in interest rates. This move is important because declining interest rates are good for prices of existing bonds. So, when the general level of interest rates decline, the value of existing bonds go up and this contributes positively to bond fund investment results.

In fact, a significant portion of the recent excellent performance in the bond market is directly related to a decline in the general level of interest rates.

Here's Why It Will Be Harder for Bonds

With current yields of bond funds approximating 4%, the general level of interest rates must continue to fall to produce performance results for bond funds comparable to what we have seen for the past several years. But, how much lower can interest rates fall? The fact is that interest rates for long-term (30 year) U.S. government bonds are the lowest they have been in over 40 years! Can they go lower? Sure, anything is possible. But, you should be very skeptical of expecting future bond fund performance returns anywhere near what we have recently observed.

So, What's an Investor to Do?

Now more than ever it pays to diversify your assets among the broad asset categories, which consist of stocks, international stocks and fixed-income investments. By your having assets spread over different investments in each category, your overall investment portfolio will not experience the drastic swings in value that it would if all your assets were concentrated in one category. By way of reference, the Multiple Asset Fund has a diversified portfolio with 47% invested in US stocks, 35% invested in fixed-income investments, 15% in international stocks and 3% in emerging markets.

Also, consider consulting a fee-based certified financial planner. Such an individual will evaluate your overall financial picture, understand your financial goals, and assess your risk tolerance and develop with you a plan that will help you attain your financial goals.

But no matter what you do, think very carefully before you invest your hard-earned savings in funds that have produced the best most recent performance. Don't make the same mistake that many investors do of buying high and selling low.