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 certainly 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 hard-earned 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 endanger 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." Savings flowed at unprecedented levels to highly speculative investments only to vanish when the bubble burst.

During times of broad-based market volatility it’s not uncommon for fear to dominate investor emotions. Undoubtedly, we have witnessed record withdrawals from stock mutual funds and record deposits into bond mutual funds. Why?

Those with savings to invest seek peace of mind in fixed-income instruments such as bond funds which appear to represent the better investment opportunity given recent performance in the highly volatile stock market.

Make Sure You Understand a Bond's Actual Return

It is 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 one determine a portion of the actual rate of return on your investment.

Of course, there are additional factors that affect bond fund performance. Nonetheless, the current yield certainly is a good place to start. A popular bond index to review is the Barclays Capital Aggregate Bond Index.

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, WorldCom, Bear Stearns, Washington Mutual, and Lehman Brothers should immediately call to mind an understanding of negative credit events.

Understanding the influence of changes in interest rates, however, is a bit more complicated. As you may be aware, the Federal Reserve System exercises a great deal of responsibility in maintaining the stability of the nation’s economy by establishing interest rates. For example, when the U.S. economy weakened in 2001 fueled by the devastation of 9/11, the Federal Reserve reduced the cost of borrowing by lowering interest rates. This move was important because declining interest rates are good for existing bond prices. 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.

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 domestic stocks, international stocks and fixed-income investments. By having your assets spread over different investments in each category, your overall investment portfolio will not experience the volatile 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 investments in U.S. stocks, fixed-income investments, international stocks and emerging markets.

Also, consider consulting a fee-based certified financial planner. Such an individual will evaluate your overall financial picture, understand your financial goals, assess your risk tolerance and develop 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. Do not make the same mistake that many investors do of buying high and selling low.