Limit loss by studying up on volatility

Want to avoid big fund losses the next time the stock market falls on its keister? Spend a few minutes learning about the concept of volatility.

Past performance alone is a poor indicator of how a mutual fund will behave in the future. About the only accurate statistical measure of how a fund will perform relative to its peers is its expense ratio (the lower the fees, the better a fund's relative performance).

But if you want to know how well -- or how poorly -- a fund will do in both strong and weak markets, you want to know about its volatility. And the best tool for determining a fund's volatility is standard deviation, a statistic that measures how much a fund's returns have bounced around from month to month. Standard deviation does a superb job of predicting how well your funds might hold up relative to other funds in bad markets. And it does an equally good job of predicting how fast your funds might rise in bull markets.

For this article, I asked Morningstar to divide all diversified domestic stock funds into quartiles, from the most volatile to the least volatile. The result: Stock funds that were the most volatile -- that is, had the highest three-year standard deviation before the most recent down market began -- plunged an average of 46 percent during the bear market, which ran from Oct. 9, 2007, through March 9, 2009. By contrast, stock funds in the least volatile quartile fell an average of 41 percent.

Foreign stock funds followed the same pattern. Foreign funds in the most volatile quartile tumbled an average of 49 percent in the bear market. Those in the least volatile quartile slid an average of 45 percent.

Morningstar found similar results for large-, mid-, and small-cap stock funds, as well as for both growth and value funds. (The relationship also held true for bond funds, although up-and-down cycles for bonds normally differ from those of stocks.)

Of course, losing 41 percent instead of 46 percent may be cold comfort. But I'll take a relative advantage of five percentage points anytime. Holding less-volatile funds during a typical bear market -- one that clips prices by about 30 percent -- can be a real game changer.

Remember that standard deviation cuts both ways. From the March 9 low through September, the most volatile diversified U.S. stock funds shot ahead an average of 70 percent, compared with 60 percent for the least volatile funds.

Volatility is important not only because it gives you a sense of how a fund will perform; it also provides some insight into how you will behave. Investors are much more likely to stick with low-volatility funds than high-volatility ones over the long term. People tend to buy high-volatility funds after they've experienced big run-ups and to sell them after they've had big losses. Timing of this sort is a formula for poor performance.

The Kiplinger 25 funds include some with relatively low volatility, as well as some with relatively high volatility compared with other stock and bond funds. The funds' volatility are categorized by decile, or groupings of 10 percent. For instance, FPA Crescent (symbol FPACX), which ranks in the least volatile decile, lost only 27.9 percent during the 2007-2009 bear market. CGM Focus (CGMFX), which is in the second-highest decile, plummeted 58.3 percent.

Both are good funds. But you should know what you're getting into when you buy a volatile fund such as CGM Focus. It's suitable for the riskiest part of your portfolio -- but not for the main course. Resist the temptation to dump the fund when its manager stumbles. By contrast, you should expect a much smoother ride with FPA Crescent, which at last report had less than one-third of its assets in stocks.

It's important to measure the volatility of your entire portfolio as well as of individual funds. By combining funds that behave differently in varying market conditions, you can build a portfolio with relatively low overall volatility, even if some or even all of the funds are volatile standing alone. But because nearly all asset classes fell in unison last year, the predictive value of portfolio standard deviations failed miserably during the bear market.