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Stern Advice: Watch for that mutual fund pop

PTOLEMY MODEL OF EARTH CENTERED UNIVERSE.
PTOLEMY MODEL OF EARTH CENTERED UNIVERSE.

By Linda Stern

WASHINGTON (Reuters) - Next month, something very dramatic is going to happen to most stock mutual funds. In fact, it's already started to happen.

The dramatic event is this: Those funds will hit the three-year anniversary of the nadir of the market in March 2009. And that means their three-year-return numbers will start to look amazingly good.

Think I'm being hyperbolic? Think again. The most widely held mutual fund -- the Vanguard Total Stock Market Index Fund -- is up at an annual rate of 30.23 percent from March 6, 2009 (the trough, by some measurements) through the end of last month, January 31, 2012. Dial those numbers back by six months -- from before the 2008 decline to before the big 2012 gains -- and the average annual returns for the same fund are 0.91 percent for the three-year period between August 29, 2008 and August 30, 2011.

"I'd be cautious about taking these new three-year annualized returns and saying: 'Wow, this fund is great!'" says Tom Roseen, an analyst with mutual fund research firm Lipper, a Thomson Reuters company. He ran all of the numbers for me. Another example: the also widely held Vanguard Index Trust 500 Index Fund is up 28.66 percent from the trough through the end of last month, but up only 0.3 percent for the three-year period ending August 30, 2012.

So, buyer beware. Roseen says there are several take-aways from these numbers. Here are a few.

-- Past performance REALLY doesn't guarantee future results. Mutual fund investors are used to seeing those words, but it's hard to imagine a better illustration of how true they are. Especially during volatile markets, the starting and stopping dates are probably the most important factors in how a fund's performance looks, statistically.

-- Lots of people missed out. "People who got out of the market and stayed out; those who are still hesitant to get back in, have really missed the party," says Roseen. Who wins in the stock market now? "Those with the fortitude to be contrarian," he says. "If you're doing what makes you uncomfortable, you're probably right."

To earn money in a stock market like this, you don't really have to be trading wildly; you just have to stick with a plan. People who stolidly kept putting money into the market (say, through weekly retirement plan contributions) despite the declines, and then rebalanced regularly, probably did even better than these averages, he said.

-- Don't buy mutual funds on the basis of one performance number or another. If you are shopping for a new fund, say to fill a hole in your retirement plan or other portfolio, first make sure that it has the right kinds of securities and objectives to actually fill that hole. Compare its performance over different periods with the performance of other funds in its same category. Check the Lipper and Morningstar ratings of the fund. Look at fund fees and make sure the amount you might be paying for outsized performance doesn't eat it all up.

-- Diversification lives. The main lesson to be learned and relearned is that it's good to figure out the right mix of several investments - stocks, bonds, foreign holdings - for your objectives and then stick with that mix. The rebalancing among asset classes will protect you from being too far in or out of any particular market at any time.

As I write this, I see a line scrolling by on a popular investment-oriented television network. "Stocks: Time to be all in?" it says. Riiight. Just like it was a good idea to go all out three years ago.

(The Personal Finance column appears weekly, and at additional times as warranted. Linda Stern can be reached at linda.stern@thomsonreuters.com; Linda Stern tweets at http://www.twitter.com/lindastern.;

Read more of her work at http://blogs.reuters.com/linda-stern;

Editing by Gerald E. McCormick)

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