By Mark Jewell
AP Personal Finance Writer
BOSTON (AP) — The recipe for successful investing sounds pretty simple: have reasonably good timing over the long haul and avoid big mistakes. That’s what helps professionals build a worthy track record. For average investors, it’s advisable to set the bar lower. Construct a balanced portfolio of low-cost mutual funds, make regular contributions to invested savings, and stick with it until it’s time to retire.
The problem is that many investors seem to think they’re better than that and can beat the stock market. Yet research consistently shows that it’s a fool’s game.
The latest findings are from Morningstar Inc., which compared the performance numbers that mutual funds posted with the returns that the investors in those funds actually obtained over multiple years. It’s typical to see gaps between the figures. That’s because investors move cash in and out as markets rise and fall, and consequently don’t experience the same results as the funds they invest in.
Sizing Up the Problem
Funds posted an average annualized return of 7.1 percent over the past 10 years, through the end of 2012, Morningstar found. But the returns that investors actually realized were a full percentage point lower: 6.1 percent. Those totals factor in all stock funds and bond funds that Morningstar tracks, as well as both individual investors and institutional shareholders.
If the percentage point gap between the figures seems modest, you may be underestimating the impact of compound interest. Small differences really add up over time.
Gaps between fund returns and what Morningstar calls “investor returns” can vary widely, but the investors almost always underperform. Over the past 5 years, funds posted an average annualized return of 2.0 percent to 1.5 percent for their investors. Over 3 years, the gap was smaller: 7.6 percent for funds to 7.4 for investors.
Irrationality Takes Over
The findings confirm that fund shareholders are often their own worst enemies.
“When people don’t hold on to funds for long, you’re generally going to have a bad result,” says Russel Kinnel, Morningstar’s director of fund research.
Fear and greed often take over, particularly when stocks are veering wildly up and down. Many investors latch on to a hot stock or fund too late and miss most or all the upside. When the market declines, they bail out and don’t participate in the eventual rebound.
With stock prices currently near five-year highs, it’s instructive to consider lessons learned a dozen years ago. When technology stocks and Internet funds surged in the late 1990s, investors piled in. But many got in too late, and reeled when the tech bubble burst.
There are examples of funds whose investors have outperformed the funds themselves. That occurs when a shareholder invested in the fund when it delivered its strongest returns, and didn’t keep cash in the fund when it was underperforming. But those instances are comparatively rare.
A Note of Caution
The more volatile a fund’s returns are, the more likely its investors won’t enjoy the full returns of the fund. One example is Fairholme Fund (FAIRX). It’s long been one of the top-performing large-cap value stock funds because of the high-conviction approach of its manager, Bruce Berkowitz. Fairholme typically invests in just a couple-dozen stocks, and in recent years invested heavily in financial services stocks, such as AIG and Bank of America.
The fund’s performance has been extremely erratic the last two years: a 32 percent loss in 2011, followed by a nearly 36 percent gain last year. The rollercoaster ride hasn’t been particularly good for investors, despite Fairholme’s 10-year average annualized return of 11 percent through the end of January. Over that period, its investors averaged 3 percent, or nearly 8 percentage points less, according to Morningstar’s calculations.
A Dose of Discipline
“The better you know yourself — what you’re good at, and when you get emotional — the better you’re likely to do as an investor,” Kinnel says.
If you know you’re prone to making rash short-term moves, it can be worthwhile to check how a fund’s posted returns differed from the results investors experienced. If there was a sizable gap, it means the fund’s investors have, on the whole, had poor timing. That could increase the chance that you won’t fare well either.
To assess the gaps between a fund’s past returns and its investors’ results, click on the performance tab for individual funds listed on Morningstar’s website. An “investor return” page provides data on the gaps.
How much of a gap is too big? There’s no hard rule. One option is to consider that the average gap for all funds has been nearly a percentage point over the latest 10-year period. Anything larger than a percentage point gap in a fund’s 10-year results may suggest some additional diligence is warranted.
Be careful, however, in reading too much into a fund’s gap over just a few years. Cash flows in a given period can be affected by factors that have little to do with investors’ decisions. Examples include a fund that closes to new investors for a period of time, or one that launches after a period when stocks have fallen sharply, and few investors are buying.
Says Kinnel: ‘There can be quirks, so it’s important to look at the big picture.”
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Questions? E-mail investorinsight@ap.org.
