As we noted last time, just using price change as the way to make our selection of the top Fidelity Select Fund, has historically been profitable, but can be volatile and have some breathtaking drawdowns along the way. We’ve also written in the past about the problems with volatility when trying to identify the best mutual funds.

As an example, take a look at the plot below. It shows some recent price action from FSVLX and FSCGX for about one month. As you can see, they both have about the same percentage price change over the last month, but the red line (FSCGX) is much less volatile, and just looking at it you would suspect that it is more likely to be in a true uptrend than FSVLX over this same time period.

So in our rankings to find the best mutual funds to trade we factor in the volatility over the recent past. This is not a new concept, for example the Sharpe ratio is a well known concept in financial circles, which attempts to capture the risk/ reward ratio of an investment by normalizing the excess return to the volatilty of the recent return. The volatility that we use is the standard deviation of the daily percentage change in price.

The metric we use differs from a standard Sharpe ratio in that it uses an exponential weighted average of the recent daily returns for the Select mutual funds, and the volatility is measured over a longer time frame than the price change (closer to 2 months). This gives us a measure of the recent month’s price action, and by normalizing to volatility we are more likely to have found a trending mutual fund.

Next we will take a look at going to cash when everything is going bad.