Editor’s note: There will not be a market report next week. I’m committed to spend the week at Scout camp and won’t have access to a phone, let alone a computer. The following week I have a family commitment so the weekly report will be a day early. So our next report will be sent on July 26.

Before I delve into today’s topic, let me just warn everyone that the market activity of the past couple of days is very troubling. A week ago, it appeared that the markets had bottomed and were poised for a new advance. Now major indices have broken below the earlier lows and the next support level could be several percentage points away.

The chart below shows that the Nasdaq is very close to the low from October 2005. If it breaks below that level, it could easily drop all the way to the level marked as “Support 2,” set in May of 2005. That’s slightly more than 7% below where it is now. Investors holding any long positions should think about stepping to the sidelines if stocks drop below the current level. We need to see stocks build some support here to prevent a more serious meltdown.

Mutual funds are alive and doing well

A couple of years ago, it appeared that the future of traditional mutual funds was uncertain. The mutual fund industry was rocked with scandal and investors were fleeing in droves for exchange-traded funds (ETFs) and hedge funds. About 91 million Americans own mutual funds. That is essentially one of every three people in the country, including men, women and children.

According to a July 11 BusinessWeek Online article, total mutual fund assets have reached an all-time high of $9.5 trillion today, compared to about $7 trillion in 2000. That is impressive, considering the amount of money lost and moved out of funds when the technology bubble collapsed and markets plunged in 2001 and 2002.

Unfortunately, being a successful mutual fund investor involves more than choosing one of the more that 6,000 available funds and hanging on for a decade or so. Finding the gems among the rubble can be an arduous task. There is far more to consider than just performance, although ultimately that might be the most critical selection component. How a fund achieves its return will determine whether or not it is suitable for a given investor.

Volatility is probably the most important selection criterion other that performance. With investing, volatility is kind of like the G force of a roller coaster or jet plane. All investors want to earn the highest possible return. But a high return is usually accompanied by high volatility–something most investors really can’t stomach. So the goal of every investor is to achieve the highest possible return based on the amount of volatility that he can tolerate.

Normally, volatility is measured by either beta or by standard deviation. Beta is really a measurement of correlation and the S&P 500 is usually used as the basis for comparison. If a fund has the same amount of volatility as the S&P 500, the beta is 1.0. A higher beta means higher volatility. A fund with a beta of 2.0 would be twice as volatile as the S&P 500. A fund with a beta of .50 would only be half as volatile. Standard deviation is a statistical measure that indicates how far something moves from its mean. So if the S&P 500 has a standard deviation of 10 and a given fund has a standard deviation of 15, it means the fund is 50% more volatile than the S&P 500. Both of these measures have weaknesses that we don’t have time to discuss today.

Most investors, when trying to choose a fund to buy, look only at its performance history. Here are a few of the problems that can be overlooked when choosing a fund solely on the basis of performance:

1. Long-term performance is good, but fund is in a recent downtrend.
2. Short-term performance is good, but fund is in a long-term downtrend.
3. Short-term and long-term performance is acceptable, but the fund is very volatile.
4. Fund performance has been great and volatility is acceptable, but fund is overweighted in an industry sector that is on the verge of a major correction.
5. Fund performance has been great and volatility is acceptable, but long-term fund manager was just replaced by someone with little experience.
6. Fund performance has been great and volatility is acceptable, but major stock markets are all overdue for a major correction.

Instead of just looking at performance, an investor should select funds based on several criteria:

1. Short-term performance.
2. Long-term performance (consistency over 1, 3 and 5-year periods).
3. What is the volatility?
4. The fund should be in a long-term uptrend.
5. How has the fund done compared to its peers? In other words, if it is a small cap value fund, is it near the top of the rankings for that type of fund?
6. How does the fund perform during corrections? Virtually all funds will correct during a major market downturn, but some will decline more gradually.

I’m going to give you some data on three funds and the S&P 500. The table shows the fund symbol, year-to-date performance, the annualized performance returns over 1, 3, and 5 years, and the beta.

If this is all the information they have to make a decision, most investors are going to choose either the fund that has the best year-to-date performance or the one that has the best annualized long-term performance. While that seems to make sense, let’s see how it looks on a chart:

The fund with the best annualized performance is EUROX, an Eastern European international fund represented by the black line. Although this fund is up nearly 80% over the past two years, it provides investors with a wild ride. An investor who bought the fund at the peak in May 2006 would have seen two-thirds of his original investment disappear in the first month. An investor who bought at the bottom in June 2006 gained 25% in the next two weeks. Not many investors can stomach those extreme swings.

The red line is Fidelity Select Energy Service (FSESX). This fund is up nearly 15% this year and is up more than 100% over the past two years. But it has also had some head-spinning declines, including a recent drop of about 40%. Answer honestly–if your investment manager told you to buy this fund and it dropped 40%, would you be calling up and screaming to know what the heck he thought he was doing?

Royce Total Return Fund (RYTRX) is the blue line. it is up about 18% over the past two years and is only slightly more volatile that the S&P 500, represented by the gold line.

Investors choosing mutual funds need to have realistic expectations. There are always funds out there that have impressive returns, but chasing those returns is virtually a guarantee for disappointment and possibly financial disaster. If you don’t know how to determine realistic expectations and set realistic financial objectives, you might need to consult with a professional investment advisor.

Remember the tech crash that began in 2001? The Nasdaq is still more than 60% below its 2001 high. A responsible investment professional knows that he cannot put the bulk of a retired investor’s assets into an investment that carries the risk of a 70% loss. If he does, he’ll soon find himself out of business.

If you elect to manage your own investments, you need to create a game plan that includes volatility as well as performance as parameters.