If you're looking for a mutual fund that invests in stocks, would you want a fund that calls itself "relatively conservative" and that the prospectus says attempts to prevent losses as well as achieve gains? This fund has posted solid long-term returns, losing money in only two of 23 full calendar years since inception.

Or would you prefer a fund the prospectus says "may establish relatively large positions" in securities it finds attractive? (That means it may buy a lot of them, which may increase risk.)

For the past 10 years, this fund has beaten the Standard and Poor's 500 stock index by about 9 percentage points a year on average, and the Lipper Mixed-Asset Target Allocation Growth Funds index by about 4.8 percentage points a year. But the fund lost 41 percent during the market meltdown from Oct. 9, 2007 to March 9, 2009.

OK, that was a trick question because I'm talking about the same fund; T. Rowe Price Capital Appreciation.

I am in no way picking on the fund or T. Rowe Price, which is a reputable firm. I would include its Capital Appreciation Fund on any short list of "moderate allocation" equity funds worth considering. I'm merely using it as an example of the inherent risk of investing in stocks and of making decisions based on partial information.

Specifically, I want to discuss how to make better sense of a fund's performance numbers.

Past performance, as regulators require funds to say, is no guarantee of future results. It isn't, but past performance can help uncover risk.

Always ask the fund company and/or person trying to sell you a fund to tell you not only its average annual return over different time periods, such as the past five or 10 years, but also year-by-year results (the prospectus will typically list returns for recent years, but not necessarily all since inception). Average returns may mask wild swings in year-to-year returns, a sign of a fund's volatility.

Also look at a fund's return compared to an appropriate index or benchmark. A fund may be down simply because the overall market is down, and even good fund managers have bad years. But a fund that consistently trails its index, even when it makes money, is hardly worth it unless it also lowers your risk of loss in bear markets.

Of course, you want more than good "relative performance," or how a fund does compared to an index. During market declines, advertisements always seem to pop up boasting how a fund has "beaten the market" in recent time periods. If you look at the fine print, you may discover the fund's returns have been puny, or the fund has even lost money, just not as much as the index.

To get a handle on potential losses, ask about returns during bear markets and worst 12-month period, not necessarily worst calendar year. Few people invest only on Jan. 1, and the worst returns may occur at other times.

Also ask about the fund's worst "drawdown" or maximum cumulative loss from a peak to a trough. That's a number a fund prospectus is not required to disclose but that some fund analysts consider the ultimate measure of a fund's risk. For the do-it-yourselfers, at the free Web site quote.yahoo.com (no www), after you enter a fund's ticker symbol in the "get quotes" window, you can get performance numbers over different time periods, and share prices over time.

 

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Investing - Mutual Fund Performance Numbers Can Be Misleading | Successful Investing

(c) 2010 Humberto Cruz