How Investors Beat Themselves

“Surprise! The returns reported by mutual funds aren’t actually earned by mutual fund investors.” This is how John Bogle, founder of Vanguard Mutual Funds begins the chapter titled The Grand Illusion in his 2007 book, The Little Book of Common Sense Investing. The “grand illusion” Mr. Bogle is referring to is the fact that mutual fund investors consistently fail to earn the returns of the financial markets. According to Bogle, during the 25 year period from 1980 to 2005, while the return on the stock market (as measured by the Standard & Poor’s 500 index) averaged 12.5% per year, the average fund investor earned a mere 7.3%, or less than 60% of what the average fund returned.

More recent studies including the annual survey conducted by Dalbar Inc., a Boston-based financial research firm support Bogle’s conclusions and have produced an even more grim assessment of the track record of the average investor. For the twenty-year period ending December 31, 2010, the average stock mutual fund investor earned 3.83% compared to the S&P 500 return of 9.14%. For the same period, the average bond mutual fund investor earned 1.01% compared to the Barclays Aggregate Bond Index return of 6.89%. In other words, even though they took 100 percent of the risk, stock and bond mutual fund investors captured only 42 cents and 11 cents respectively on every dollar that was available to them. To make matters worse, after adjusting for inflation, the average investor barely broke even.

To put this dismal performance in stark dollars and cents terms, using Dalbar’s survey results, a $100,000 portfolio consisting of 50% stocks and 50% bonds invested for thirty years (a conservative time horizon for most people) could have grown to $1,067.000 by simply allowing the money to capture the returns of the stock and bond markets. Instead, the average investor saw their portfolio grow to only $222,000 thereby giving up $845,000 or 80% of the returns available to them. This will likely have enormous implications for an individual’s or family’s future.

What’s the reason for such a stunning performance gap? Although roughly 2% of the lag can be attributed to the unnecessarily high fees that investors pay to own the average mutual fund, the main cause is the investors’ own behavior, specifically counterproductive market timing and fund selection. Stated simply, investors chase performance, pouring money into those asset classes (e.g. stocks, bonds, etc.) and mutual funds that have recently experienced the biggest gains, only to lose conviction and sell after experiencing an inevitable and painful decline.

Buying high and selling low is obviously a flawed investment strategy. Yet many investors fail to practice what common sense dictates and make this mistake repeatedly, causing permanent damage to their portfolios. At some level, this disconnect between rational thinking and emotional behavior is understandable because investment decisions are different from other types of decisions we make in life. With non-investment decisions, past experience is often a reasonable predictor of future performance. With investing, however, often the opposite is true. Not only is past performance an unreliable predicator of the future, but recent past performance is in fact often a contrary indicator of what’s to come. In other words, the types of investments that have recently declined in value the most may prove to be the better performing investments in the future. Unfortunately, this contrarian approach is easy to understand intellectually but emotionally difficulty to implement. This is especially true during times of financial crisis when otherwise rational people are overcome with the fear that the future will bring even more bad news.

As powerful as emotions are and as difficult as they may be to overcome, to be successful, investors must do so. It begins with a realistic understanding of how the financial markets work. Sudden surges and frightening drops in the market are to be expected. The successful investor will avoid making impulsive decisions and instead, employ a long-term investment plan rather than succumb to the emotions of greed when the markets surge and panic when they plummet. It’s clear that investors consistently fail to earn to returns that they should. It’s time to change that.

 

This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.

About the author

John Spoto, CFP®

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