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After The Dust Has Settled

Out With the New, In With the Old: Recent Stock Performance Shows Established Rules Still Apply


If only it wasn't real money, investors might be able to laugh about the lessons they learned in financial markets in the first quarter and over the last 12 months.

In retrospect, it seems absurd to many people that they--or anybody--paid last year's prices for then-highflying "growth" stocks. It also seems absurd that investors ignored for so long the now-obvious appeal of more conservative investments such as bonds and "value" stocks for at least a portion of their portfolios.

If those lessons didn't become clear enough in 2000, they were brought home with a vengeance in the first quarter of this year. Large-growth stock mutual funds, the type most popular with investors, sank nearly 20%, on average, in the quarter. It was the worst quarterly performance since the market crash of 1987, according to fund tracker Morningstar Inc.

Worse, those growth funds--often loaded with tech shares--on average fell almost 35% in the 12 months ended March 30. That's the deepest decline since 1973-74.

The average U.S. stock mutual fund dropped 12.9% in the quarter and is down 17.2% over the last year.

Meanwhile, the bond mutual funds that many Americans dismissed as "too boring" in the late 1990s have in some cases racked up double-digit returns over the last year. Amid a slowing economy and crashing corporate earnings, some investors suddenly were happy to trade shares of flimsy tech firms for securities that paid hard interest.

The good news about the last year, painful as it was for most portfolios, is that it may leave a lasting impression, experts say. A lot of half-baked ideas about investing have been swept away. As the dust settles, people have a chance to improve their odds of long-term financial success by focusing on diversification, weighing risk against potential return and asking not, "How much can I make?" but, "How much do I need to make to reach my goals?"

"Twelve months ago, the conventional wisdom was that diversification didn't matter anymore and all you needed was large-cap growth and technology," said Don Phillips, managing director of Morningstar.

"The other important lesson is that you have to understand your risk profile," he said. "Too many people got lulled into the 'new-economy' hype. In this business, the most dangerous words you can ever hear are, 'It's different this time.' "

What's never different, financial advisors say, is the need to spread your money around different types of assets, so you aren't overly exposed if one market sector is devastated--as growth stocks have been for 12 months.

In the first quarter, as the bear market deepened, it was tough to make money in any stock fund. But the magnitude of the losses varied widely by sector:

* At the bottom, to no one's surprise by now, were tech funds: They sank 34.7%, on average, according to Morningstar, compounding the average loss in 2000 of 33.2%.

But it's important to keep some perspective: Despite the bursting of the tech-stock bubble, the average tech fund still had a 10.3% annualized gain for the three years ended March 30--triple the average U.S. stock fund's return.

* All three growth-stock sectors--large-cap, mid-cap and small-cap--were walloped in the quarter. By contrast, small-cap and mid-cap growth stocks held up well for much of 2000, even as big-name growth stocks slumped.

Mid-cap growth funds slid 22.5% in the quarter, on average, while small-cap growth funds dropped 17.9%.

* At the top of the performance list for the quarter were small-cap value funds, which eked out a 0.7% total return. That was the only category to post positive results for the quarter.

Small-cap value stocks--names such as retailer Pier 1 and home builder D.R Horton--had been among the most unloved issues in 1998 and 1999. Now, the market has become far more excited about stocks with low price-to-earnings ratios and steady, if not spectacular, growth prospects.

* Though mid-cap and large-cap value funds lost ground in the quarter, their losses were relatively modest: mid-cap value eased 2.9% while large-cap value fell 5.8%.

The market's appetite for value also showed in the relatively small losses incurred by traditional value sectors, such as real estate funds, financial services funds, natural resources funds and hybrid/balanced funds (which own stocks and bonds).

Meanwhile, funds that invest in foreign stocks again turned in a disappointing performance. The average foreign fund lost 14.3% in the quarter, clipped not only by losses in overseas markets but also by the dollar's strength--which automatically devalues foreign assets held by Americans.

For many investors, the questions of whether and how much to shift their portfolio mix now center on one key question: How long will smaller and more value-oriented stocks keep the lead in this market?

Typically, cycles of large-cap or small-cap dominance have lasted longer than cycles of growth or value dominance--but there are no guarantees, said Brad Lawson, senior research analyst at financial firm Frank Russell Co.

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