Volatility costs you money and sleep. A broadbased portfolio will serve most investors well.

Investors hate volatility, the ups and downs in our investments. (To be more precise, we hate
the downs - the ups we don't mind so much.) And we pay a big price for that volatility - not
just stress and lost sleep at night, but volatility induces behaviour that costs many of us serious
money.

Lots have been written about the twin emotions of fear and greed that cause investors to buy at
the top (when greed prevails) and sell at the bottom (when fear takes over) - quite simply,
most investors don't have the stomach to ride market ups and downs with equanimity.

That's one reason investors benefit from working with a financial adviser. Good advisers serve as
an emotional anchor, keeping the highs from being too high and the lows from being too low.
But good advice isn't enough. You also need a portfolio you can live with.

At a recent conference, Don Phillips of Morningstar Inc. presented an analysis of how
U.S. mutual fund investors did in the 10 years ended in 2007, comparing this to the
performance of the funds themselves. In calculating the investor return, Morningstar factored
in when investors bought and sold, and the returns during the periods they held funds.

For balanced funds, typically conservative funds that hold stocks, bonds and cash, the annual
investor return was 7.88 per cent. Because of when they bought and sold, investors narrowly
outperformed the return they would have received if they'd bought at the beginning of the
10 years and held on - that strategy would have generated 7.80 per cent a year.

Compare that to funds invested in specific sectors such as technology, health care and
energy. The average return on these funds was 9.53 per cent - they did much better than the
stodgy balanced funds. And the investors in those sector funds? The investor return was 6.75
per cent. Investors did much better in balanced funds than in sector funds, not because the
balanced funds performed better (they actually did much worse) but because most investors
couldn't stomach the ride in sector funds.

In theory, narrow sector funds can boost returns and fit the higher risk portion of a portfolio, but
getting the timing right on these funds is incredibly difficult.
Morningstar took this analysis one step further.

For each asset class (for example, value stock funds, bond funds, emerging market funds), they
divided the participants into two categories - those whose volatility was above average and
those whose volatility was below average. They looked at the performance of the high-volatility
and low-volatility entries and compared this to the investor experience. The returns of highvolatility
and low-volatility funds were almost identical - about 6.25 per cent. Investor returns
in those funds were very different, however. The actual investor return in the low-volatility funds
was just under 6 per cent, almost matching the return on the funds themselves.

By contrast, the investor return in the highvolatility entries was 4.32 per cent - over the 10-
year period measured, higher volatility cost investors in those funds almost a third of their
potential return.

The reason that volatility extracts such a big price on investor returns is quite simple - fear,
greed and lack of patience lead to counterproductive behaviour. When faced with
volatility, most investors typically buy and sell at exactly the wrong times.

There are some important lessons here for investors, financial advisers and mutual fund
companies.

First, fund companies that focus on narrow sector funds don't typically do investors any
favours - it's clear that most investors are best served by broader-based entries.
Second, it's not just returns that count, the volatility accompanying those returns is
important. Performance has to come first - after all, that's what managers are paid for - but even
for offerings in higher-volatility categories such as emerging markets, fund companies should
strive to have their funds operate with as little volatility as possible.

Advisers need to be aware of the risk of putting their clients into volatile investments such as
narrow sector funds, even when clients ask for them.

And if advisers have a choice between recommending two alternatives with similar
performance histories, clients will almost always be better off with the less-volatile choice.

The real cost of volatility