High-risk funds rarely pay off, even for young investors
— -- You're young. You're daring. And your 401(k) portfolio looks like your first car after it rolled into Dry Gulch Creek. What should you do? Invest like an old fogey, that's what.
Financial planners often tell young people to buy risky funds, but that's not the best advice. Young people don't need risky funds because they have plenty of time. And risky funds rarely produce sky-high returns over the long term.
Although young people do have time to repair blunders, some mistakes are easier to make up for than others. It's easier to replace a bumper, for example, than to extricate your car from Old Man Taylor's credenza.
Some of the most speculative funds crashed in the last bear market. Consider the ProFunds UltraBull fund, which uses futures and options to rise (or fall) two times as much each day as the Standard & Poor's 500-stock index. If this fund were a car, it would be the Batmobile. It has soared 93.4% since the bull market began on March 9.
UltraBull turned into a joker during the bear market, however, and plunged 70.2%. You'd think that the good times make up for the bad. You'd be wrong. The fund has fallen 76% the past decade.
In the very long term — 20 to 30 years — the riskiest types of funds really haven't paid off. Small-company stocks, for example, tend to have bigger moves up and down than their larger, stuffier brethren, but they also have more growth potential. That's why planners often recommend small-cap funds for younger investors.
Unfortunately, that advice hasn't worked out too well for the past quarter-century. For example, the Lipper Small-Company Stock Fund index has gained 634% the past 25 years. Not bad, but the Lipper Equity Income Fund index has jumped 766%. Equity-income funds invest in stocks of big, dividend-paying blue-chip companies, the kind you associate with pensions and your great-granddad's trust. Top fund categories the past 25 years:
•Midcap value, up 945%.
•Large-cap value, 893%.
•Growth and Income, 801%.
(If you're not fluent in fund classification: Value funds look for stocks of beaten-up companies that have the potential to recover; midcaps are stocks of midsize companies; and growth-and-income funds are cousins to equity-income funds, but more concerned with growth of principal.)
Why stodgier funds have done well:
•They often invest in dividend-paying companies, and dividends are a powerful boost to performance. The S&P 500 has gained 793% the past 30 years without dividends; it's up 2,046% with dividends.
•They don't fall as far. A fund that falls 50% has to gain 100% just to get even. But many hot funds never rebound as fast as they plunge. (One exception: ING Russia, down 71% in the bear market, yet up 629% the past decade. Give those guys some vodka.)
•They're more diversified. Highly specialized funds, such as those that invest only in stocks of steel manufacturers (yes, there is one), are risky by nature. Larger funds spread out their holdings among different sectors of the stock market, which helps reduce risk somewhat.
Conservative funds also have particular advantages for younger people. They're good starter funds, because when you're young, you don't have much money, and you often hate to lose it.
And, says Tiburon, Calif., financial planner Kurt Brouwer, you shouldn't use your 401(k) money for speculative matters, anyway. "You should take more risk with money that's not essential for life," he says.
The funds in the chart won't ever be in front on the mutual fund speedway. But you won't have to haul their wreckage from your portfolio, either.
John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is jwaggoner@usatoday.com. Twitter: www.twitter.com/johnwaggoner.