An Ugly Market's Lessons for Investors

By SHEFALI ANAND

It's been almost a year -- a long and painful year for investors -- since stock-market benchmarks including the Dow Jones Industrial Average hit record highs last Oct. 9. The stormy markets since then have caused much upheaval for mutual-fund investors, but also highlight important lessons.

Chief among them: Some supposedly safe investments aren't as secure as investors thought. And diversification doesn't always prevent losses in the short term.

Looking at the 12 months through Sept. 30, the Dow industrials fell 22% (before dividend income). Fund investors didn't find many places to hide because almost all types of funds, including those which invest in bonds, precious-metals stocks and foreign stocks, were hit.

Very Few Winners

Of the 69 stock- and bond-fund categories tracked by research firm Morningstar, only eight had positive returns for the 12 months through September. These are funds which invest in U.S. bonds, short-term municipal bonds and -- the big winner, up 22% -- "bear market" funds which bet against the stock market.

Looking at 2008 to date, meanwhile, the average diversified U.S.-stock fund is down 20% through Sept. 30, according to Morningstar.

One of the biggest surprises this year came from problems with investments which were perceived to be safe. These include money-market funds, which strive to maintain a $1 share price, and ultrashort bond funds, which had been marketed as conservative investments which provide better yields than money funds.

Last month, a big money fund, the $62 billion Reserve Primary Fund, saw the value of its holdings fall to 97 cents a share, due to its investments in Lehman Brothers Holdings, which filed for bankruptcy protection. Concerned about a possible run on other money funds, the U.S. stepped in with a plan to temporarily back the funds.

Also in the past year, several ultrashort bond funds lost 10% to 30% of their value, because they were holding exotic investments which became hard to sell amid the credit crunch and which fell in price.

This reiterates the need for investors to pay attention to the risks of their investments, and not rely on what a broker or marketing material may describe as safe. Also, "it points to the risks of chasing yield," says Christine Benz, director of personal finance at Morningstar.

Reserve Primary Fund's 12-month yield of 4.04% as of Aug. 31 was the highest among 2,100-plus money funds tracked by Morningstar -- far above the average 2.75%.

Ms. Benz says that if investors find that their money fund has higher than average yields, they should dig into what's driving that. "If the expense ratio isn't rock-bottom and yet the fund is at the top of the chart, that could be an indication" of higher risk, she says.

Limits of Diversification

One unsettling phenomenon this year has been that asset classes including stocks, bonds, commodities and real estate have all fallen, though to different degrees. Investors often figure that diversifying their holdings among various asset classes will make it less likely that their overall portfolio will post a loss.

Sometimes in down markets, "in the short term, diversification doesn't work," says Ross Levin, a financial adviser in Edina, Minn.

In the long run, however, asset classes don't stay highly correlated, he says. Thus, investors are best served by sticking to their long-term asset allocation plan, even if it doesn't seem to be working in the short run.

The worst-performing fund categories so far in 2008 are those that invest in foreign stocks, especially the more risky emerging markets. Stock funds that invest in Asia excluding Japan -- a category that includes funds that focus only on China or India -- are down an average 43% through Sept. 30. This is a sharp reversal from last year, when these funds topped the charts with an average return of 48%.

Not Immune to U.S. Pain

When economic problems began in the U.S. last year, many observers thought they wouldn't much impact countries like China and India, which had rapid domestic economic growth. But it turns out that these countries, too, are being impacted by a global slowdown. That spillover effect, combined with withdrawals from these markets by increasingly risk-averse investors, has sent these markets crashing.

"Globalization and other factors have led to much more interconnectedness in the financial markets," says Kurt Brouwer, a financial planner in Tiburon, Calif.

This interconnectedness has even hit high-quality corporate and mortgage bonds, which are traditionally expected to hold up when stocks decline. Recently, investors have fled various types of bonds to seek the safety of U.S. Treasurys, hurting the liquidity and prices of other bonds. The average intermediate-term bond fund, which typically invests a majority of its money in high-quality bonds, was down 4.2% for the first nine months of 2008.

Separately, high-quality municipal-bond funds have been hurt partly because of worries about the financial strength of the bond insurers that back many muni bonds. The average municipal national intermediate fund is down 2.4% so far this year.

Investors in natural-resources and precious-metals funds have been whipsawed. These funds initially held up as the broad market declined. But in the past few months, these funds have fallen sharply as the prices of oil, gold and other commodities have fallen.

Natural-resources funds are down an average 22% so far in 2008 and precious-metals funds are down 26%. Advisers typically recommend only small investments in such funds.

The recent market volatility has provided a chance for investors to reassess whether they are comfortable with the amount of risk they are taking in their portfolios. Investment adviser Roger Gibson, of Wexford, Pa., says investors hardly think about risk when the stock market is doing well, and may even resist diversifying or putting money in bonds.

Now that the risk is staring investors in the face, they can re-examine whether they are "sleeping well at night," he says.

Write to Shefali Anand at shefali.anand@wsj.com