Adherents to Old Rules of Investing Make Strong Showing in 2nd Quarter

Listen. What you hear is the sound of thousands of financial planners and mutual fund managers across the country breathing a collective sigh of relief.

Remember all those questions you’ve been asking yourself--and them--during the last couple of years?

You know, why invest in undervalued stock funds when the market is perfectly willing to overvalue large growth stock funds, or anything.com?

Why invest in a foreign stock fund returning 8% a year, when funds investing in U.S.-based multinationals are delivering 30%-plus returns?

Why dilute your returns by investing in several good stocks, when you can put all your money into one great one?

Well, the three months ended June 30 provide the perfect answer.

Consider what was hot in the second quarter: small-company funds, mid-cap funds, emerging markets funds--the laggards of the bull market during the last two years.

Now consider what was not: A number of large growth funds--the market leaders at the start of the year--lost money in the second quarter. Internet funds, which were even hotter at the start of the year, lost even more since they peaked April 13.

If the last three months teach us anything, says Bohemia, N.Y., financial planner Ron Roge, it’s that eventually, “Everything reverts back to the mean.” And that the old rules of investing--which stress patience, prudence and diversification--are back.

“I don’t think they ever went away,” says Sheldon Jacobs, editor of the No-Load Fund Investor newsletter. “The fact that something doesn’t work every quarter doesn’t mean it was ever wrong.”

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Fair enough. So let’s refresh ourselves as to what those old rules are. Among them:

* Diversification pays. Gerald Perritt, president of Perritt Capital Management, recalls teaching an undergraduate course on investing at the University of Miami.

“I was trying to explain to the class the benefits of diversification,” says Perritt, who also edits the Mutual Fund Letter newsletter. “I was explaining why you’d want to have a diversified portfolio of stocks, so that when one stock goes down, another will rise.”

At which point a young student raised her hand and asked, matter-of-factly: “Why would you buy a stock that goes down?”

Yes, why would you?

Obviously, no one can predict with absolute certainty when a stock will go down or when it will go up before it actually does.

But last year, many of us thought we could. We assumed investments in large growth stock funds would continue to rocket. And they did--until the second quarter of this year.

Which brings us back to that original point: The reason we need to diversify our investments is that it’s impossible to tell, with absolute certainty, when certain asset classes will rise and when they will fall.

The first six months of this year offer the perfect example. For instance, in January, large growth stock funds were in favor. In February, value stock funds did better. In March, the emerging markets funds busted out. That was followed in April with the rally in industrial cyclical stocks and small-company stocks. Then in May, it was small value stock funds’ turn. And in June, it was Asian stock funds again.

* Fundamentals matter. For the first time in a long time, investors care about earnings (something many Internet stocks, with no earnings whatsoever, discovered during the quarter).

Valuations matter too. Bargain stocks, those trading at discounts to their earnings or assets, fared much better during the quarter than expensive stocks with high price-to-earnings ratios.

* Foreign investing matters. The domestic stock market has been so hot in recent years that many of us were beginning to think that we didn’t need to invest abroad. U.S.-based multinationals were enough, some of us argued.

Turns out U.S.-based multinationals aren’t enough. At least they weren’t in the second quarter.

To have made real money in the past three months, you needed to be invested in a diversified emerging markets fund, or a Pacific region fund, or a Japan fund, or a Latin American fund.

* Risk-taking is rewarded--eventually. Those of you who were brave enough to buy when there was “blood on the streets” in the risky emerging markets, or who took a chance on an underperforming small-cap fund don’t need to be reminded of this point.

* You can’t follow the leaders. For years, experts have warned investors against chasing “hot” funds. The reason? By the time you get around to investing in a five-star fund that can do no wrong, it does.

But this point was lost on many investors last year. Many who chased hot funds such as Janus Twenty were rewarded handsomely.

But look at what has happened to those folks this year. If you got into Janus Twenty at its peak at the end of the first quarter, you would have lost 4.3% of your investment.

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The Times’ quarterly review of investing will appear as a separate section Tuesday. Included will be both top-rated mutual funds from Morningstar, Inc. and comprehensive listings. Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.