Where are your returns?
The investors chief problem and even his worst enemy is likely to be himself.- Benjamin GrahamWe now have living proof of the famous investors homily. Last October, Morningstar the popular investment research company began publishing investor returns alongside the standard calculations of total return for mutual fund performance. These numbers reveal the experience of the average investor in a mutual fund based upon the timing of their investments into and out of the fund.The results are not pretty. In all diversified stock-fund categories, throughout the 10-year period, investors received approximately 80 percent of the return generated by the managers of their funds. Investors would have received 100 percent had they simply employed a buy and hold strategy. In the more volatile asset classes, such as technology and emerging markets, the results are startlingly worse.
Investment performance is measured by the average annualized return. Such figures allow us to compare performance on a year-by-year basis. Critically, we use the geometric mean, which investors often confuse with a simple arithmetic mean. If an investment goes up 50 percent the first year and down 50 percent the next, the arithmetic mean is 0 percent. But thats not how we measure investment returns, because it ignores the effect of compounding. A $10,000 investment that goes up 50 percent ($5,000) in the first year will be worth $15,000. If it goes down 50 percent in the second year, it will be worth $7,500 after two years, for an average annual return of minus 13.3975 percent.
Fund performance is measured by a time-weighted return, which controls for the impacts of cash flows into or out of a fund during the course of the year. Time-weighted returns are ideal for comparing the performance among different managers or of a manger with an index. They measure the efficacy and the execution of a given strategy by the manager, irrespective of any external flows into or out of the portfolio.Investors who buy and hold neither adding nor removing money realize the time-weighted return produced by the funds advisor. But the average investor does not buy and hold. He frenetically moves money in and out of funds searching for better returns generally for naught.Investor returns are the calculation of a dollar-weighted return. Typically money flows into mutual funds following periods of strong performance and just before periods of poor performance. Investors capture the period of underperformance.Lets look at the math again. At the beginning of the year, an investor buys 1,000 shares of a fund at $10 a share a $10,000 investment. Six months later he buys an additional 500 shares at $20 a share for a total investment of $20,000. At the end of the year the value of the shares falls back to $10 each and the investor liquidates his position for $15,000. The funds total return is 0 percent for the year. But the investor experienced an annualized return of minus 32.29 percent.
The managers of Fidelity Select Technology fund produced a 9.11 percent total return for the 10-year period ending April 30, 2007. The investor return for that period was minus 3.50 percent. And, investors in index funds suffer a similar although not quite so bad fate. Vanguard S & P 500 Index fund reported a total return of 7.96 percent for the period, but the investor return was 6.80 percent.What you can do?If you move money contrary to your investment policy whether in response to changing markets or manager performance you are likely to fare no better than the investors described here. The logical approach is to choose an asset allocation strategy and stick to it rebalancing in a regular and disciplined way. Such an approach forces the investor to buy low and sell high the exact opposite of the behavior of the average mutual fund investor as revealed by Morningstars new data. And, it may even result in returns higher than that of your funds manager.Steven R. Smith, JD, CFP is the principal of RightPath Investments & Financial Planning, Inc. a fee-only Registered Investment Advisory firm in Frisco. If you have any questions or comments contact Steve at (970) 668-5525 or firstname.lastname@example.org. (Specific investments or resources mentioned are illustrations only and are not recommendations. Past performance does not guarantee future results.)
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