Are You Shooting Yourself in the Foot?
Every year we are bombarded with information about investment returns. We hear about the returns for the “market”, for individual mutual funds, and for the stock of various companies. I think the typical investor looks at those and thinks that’s what their return is too. But is it?
For years now there have been studies indicating that the actual return the average investor gets on their investments is actually less- significantly so in some cases- than the reported returns. Over time this variation can make a big difference in the eventual portfolio value. In the 20 year period between 1994 and 2013, DALBAR, a leading investment research firm, estimates the average mutual fund investor earned an annualized return of about 5% as compared to the approximate 9% of the S&P 500 index. That’s a 4% difference- annually. To put it in dollar-terms: $10,000 grows to around $26,000 in 20 years at 5% but around $56,000 at 9%. Morningstar, another investment research firm, estimated that the average return difference experienced by an investor over a 10 year period ending in 2012 was about 0.95% less than the return of the average mutual fund. The gap as measured in 2013 had increased to around 2.49%. While their methodologies are different (DALBAR compares to the S&P 500 while Morningstar compares to the “average” mutual fund), the gap is disturbing either way.
The obvious questions are: 1. Is this right? 2. Why? As to the first question, is this right? Probably. There is some strong, and I think valid, criticism of the DALBAR methodology in two areas. The first is comparing to the S&P500 rather than to either the “average” mutual fund or the index related to the fund being judged. The second criticism has to do with the impact of the timing of returns. If we assume, as is the case for most investors, that they put money into investments gradually over time rather than all in the beginning, then the impact of good (or bad) returns can be greater towards the end of the time-period being measured simply because the investor has more money in the fund/stock at that time. That said, it probably doesn’t eliminate all the difference and the Morningstar results, by a different method, also show the difference.
So that leads to the second question- why? What might cause this variation in actual vs. expected returns? The most likely explanation has to do with investor movement of their money. Market timing or chasing returns are a couple of phrases that might apply. Folks often chase the hot investment, but often after most of the above-average returns have been realized. Let’s look at a simple example. Mutual Fund ABC opens for business. Over the first 5-10 years it’s small- not much money invested. But the manager does a good job of finding good opportunities- and his/her returns begin to stand out. Money that was invested elsewhere starts to move to this fund. It grows- a lot. Whereas in the past finding one or two great investment opportunities a year lead to the above average returns, it now takes 10, 20, 50 or more a year like that to do the same. But are there that many? Can any one manager or management team find those year after year? Not likely, and so returns suffer. Overall returns for the fund over 20 years might look very good since the first 10 years were great. But the return for the investors who got in later- well- not so good. A real-world example of this might be the Fidelity Magellan fund when Peter Lynch was running it vs. when it grew to a behemoth (essentially an S&P 500 index fund).
What’s the take-away from all this? In my mind, trying to constantly find the market-beating investment, be it an individual stock or a mutual fund, is probably a good way for the average investor to significantly cut his or her overall long-term investment returns. John Bogle of Vanguard fame has long advocated long-term index investing. Famed investor Warren Buffett has been quoted as saying that once he’s gone, the trustees of his fortune would do well to consider NOT investing like him but rather to put all the money into a low-cost S&P 500 index fund and leave it alone. The lure of “beating the market” is strong- like the Sirens were for Odysseus. But I think investors are misguided in believing they need to always squeeze the last bit of return out of an investment. Long-term success in investing comes from having a sound strategy, a good saving habit, and avoiding doing things that will harm you. In many cases, this is the most valuable thing an investment professional can bring to the table for an investor. It’s about managing and avoiding both greed and panic- the two green-eyed monsters that stalk investors and lead to their return under-performance.
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