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Choosing 'non-losers' could be better than picking 'winners'

Chuck Jaffe

Publication: The Day

Published November 25. 2012 4:00AM

Shelly is a 30-something office manager in the Fort Worth, Texas, area with a new retirement plan at work and a fear of investing in the market that is keeping her from putting anything into it.

"I keep looking at the funds in the plan and I know I am supposed to pick them thinking about how much money they can make me from now until when I retire," said Shelly, whose only investment outside of certificates of deposit and U.S. Savings bonds is a balanced mutual fund account she inherited from her grandfather and has never touched. "Instead, I keep thinking about how much money they could lose for me."

What Shelly doesn't realize is that she has stumbled on a good way for a nervous investor to pick a mutual fund.

Investment analysts routinely say that average investors have been so nervous about market declines since the financial crisis of 2008 that they have missed the market's gains since. Worse, they have been losing ground to inflation by keeping their cash in instruments like bank accounts that have virtually no return.

Stuck between the twin devils of greed and fear, they might turn the typical investment-selection process on its ear, and find a way to invest that appeals to their fearful side, rather than simply hoping to develop the nerve to pursue the strategy that they think will deliver the proverbial big gains.

For investors who fear losses more than they love gains - and that includes most people - asking "Which of these funds will do best?" is less appropriate than sizing up funds by wondering "Which of these won't be too bad?"

"Too bad" would mean delivering performance that crosses the line to where the shareholder feels they have to get out.

By figuring out which funds are likely to avoid the worst performance - rather than deliver the top - investors like Shelly can improve their chance of finding funds that they can own "from now until when I retire."

"People make a mistake by looking at big returns without wondering how those returns are achieved, and what kind of performance they will have to live through to get those results," said David Snowball, who runs MutualFundObserver.com. "Very few people ask the reasonable question 'What is going to produce a sustainable return for me?'"

Snowball explored that question this month on his website by updating annual research into "Which funds are never terrible?" Specifically, he searched for no-load funds that never finished in the bottom third of their peer group over the last decade.

Thirty-three funds passed the screen. While Snowball wasn't looking for strong returns, he got consistent performers anyway, with 29 of the funds earning four- or five-star ratings from Morningstar. Ten of the funds were from T. Rowe Price, with six each from Fidelity and Vanguard. (www.mutualfundobserver.com/2012/11/november-1-2012/)

"In terrible markets, these funds are going to look pretty darned good," said Snowball, "and in good markets, they mostly won't be terrible. They won't be among the worst funds in up or down markets and, for some investors, not 'being among the worst' is a real strong point."

One thing many of the funds on Snowball's list have in common is that they give managers some leeway and flexibility, so that they can go to cash or otherwise alter the portfolio during times when they expect their corner of the market may be headed for trouble.

That's increasingly hard to find in an environment where investors, but particularly the financial-planning community, punish funds that don't do a very specific job, leaving the "in or out" questions to the shareholder/planner, rather than the fund manager.

Most funds have a mandate to invest in a specific space, say large-cap stocks, no matter what the market is doing or the prospects for the asset class. Thus, even if they foresee trouble, they can't seek shelter.

That was borne out in a recent study by financial planner Harold Evensky, which found that investors believe that using active fund managers protects them against bad markets, but that those managers seldom sidestep the market's pain. (http://www.iinews.com/site/pdfs/JOI_fall2012_E&K.pdf)

"Some of it is the managers," Evensky told me, "but some of it is also that managers are constrained as to what they can do sometimes to help investors avoid pain."

That's why the "not terrible" screen is important, because it doesn't suggest there won't be agonizing markets, but rather that there won't be a complete meltdown when things get hairy. It's low-volatility investing, rather than searching for the "best fund," which might lead to the top of the performance charts, and to funds that have the potential to someday be at the bottom of those results.

The advice for investors like Shelly, therefore, becomes "pick funds you can live with." Find out how they do their job and match their methods with your personality; if avoiding volatility and the worst of the market has the best chance of helping you grow money from here to retirement, then worry less about picking a winner than on simply choosing a non-loser.

Chuck Jaffe, senior columnist for MarketWatch, can be reached at cjaffe@marketwatch.com.

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