As you put together your portfolio, it's important to distinguish between short-term volatility and shortfall risk, and to know which one is the bigger foe.
The former is the inevitable side effect of investing in stocks and, to some extent, bonds. Long term, markets will go up at times and down at others. What's really important is that during a reasonably long period of time, your well-diversified basket of long-term securities ends higher than where it started. Shortfall risk--the possibility that you won't have enough money by the time your goal date rolls around--is obviously a much bigger concern than market fluctuations.
That said, the two concepts aren't entirely divorced from one another. As much as we often urge investors to tune out the short-term noise of the market and focus on their long-range goals instead, Morningstar data demonstrate that when investments exhibit a lot of volatility, investors tend to buy and sell them at inopportune times. For such investors, short-term volatility goes hand in hand with shortfall risk. The opposite is also true: Lower-volatility funds tend to lead to better investor outcomes because investors do a better job sticking with them through good times and bad.
To help identify core mutual funds that tend to hold up better than their rivals when the market is sketchy--and therefore could work well for worrywarts--I used Morningstar's Premium Fund Screener to search for Silver- and Gold-rated funds with Morningstar Risk ratings of low. I focused on broadly diversified funds that have minimum initial investment amounts of less than $10,000 and therefore are available to investors who are just starting out. A number of these funds have looked underwhelming during the five-year market rally, but they've earned their keep by holding up much better on the downside. Click here to view the complete list. Below are some highlights.
Vanguard Dividend Growth (VDIGX)
This fund's emphasis on mega-cap companies with a history of increasing their dividends gives it a tilt toward high-quality names with strong competitive advantages. That, plus manager Don Kilbride's focus on buying such companies at reasonable prices, has given the fund superior downside protection relative to its peers and to the S&P 500. During the past five and 10 years, the fund's losses in weak markets have been just 70% of the S&P 500's, based on its downside capture ratio. Indeed, in 2008's bear market, its 26% loss was 30% smaller than the S&P 500's loss in that year.
Jensen Quality Growth (JENSX)
Like the Vanguard fund, this offering doesn't differentiate itself in ebullient markets as much as it does in challenging ones. During the past 10 years, for example, its downside capture ratio, while not quite as impressive as the Vanguard fund's, is 20% lower than the S&P 500's. That's an outgrowth of its managers' focus on steady profitability; they look for companies that have delivered returns on equity of 15% or better in each of the past 10 years.
Tweedy, Browne Global Value (TBGVX)
This fund's experienced managers employ a value discipline, but Morningstar analyst Kevin McDevitt notes that they're willing to pay higher prices for good businesses they can own for many years, such as Nestle (NSRGY). That emphasis on quality and valuation, as well as the managers' tendency to let cash build when they can't find anything to buy, has held it in good stead in skittish market environments. Its downside capture ratio is just 70% of the MSCI EAFE's.
FPA New Income (FPNIX)
Many bond funds emphasize downside protection, but Morningstar analyst Sarah Bush notes that this one has a "singular focus on not losing money." To that end, manager Tom Atteberry has maintained limited interest-rate sensitivity for more than a decade, and has also generally steered clear of lower-quality credits. Those biases mean the fund has left some returns on the table as rates have dropped further and low-quality credits have rallied. But the fund's downside protection is second to none: It hasn't lost money in a single year since 1984. Atteberry's commitment to a low-duration stance should hold it in good stead if and when the long-anticipated rise in interest rates materializes.
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