Are You Earning the Total Returns Your Mutual Fund Offers?
By Ric Edelman
Let’s turn to data provided by Dalbar, a research organization in the financial services field. For years, Dalbar has tabulated the performance of investors rather than investments. Its findings are so important that Morningstar has adapted a similar approach for its mutual fund rating system.
How can it be that a mutual fund’s investors don’t earn the returns generated by the fund itself? The answer is simple: Mutual fund performance data is based on the returns earned from January 1 through December 31, with no cash flows occurring between these dates. In other words, the data assume you invest on January 1 and that you withdraw your funds on December 31, and further assume that you don’t add any money or make any withdrawals during the year. If you follow that protocol, then your return will indeed be identical to the returns posted by the fund.
But that’s not how investors behave. As Dalbar discovered, and as Morningstar agrees, you’re far more likely to invest in a fund on a date other than January 1. You might later make an additional deposit, and perhaps withdraw some of the money at some future date. Because investment prices fluctuate, your investment results cannot possibly match those who are basing their data on January 1 and December 31 prices.
Doesn’t this mean that investors might actually earn returns that are higher than those claimed by mutual funds? Theoretically, yes: It’s possible that you’ll buy at prices that are lower than January 1’s and higher than December 31’s. But, in reality, that’s not what happens.
By studying cash flows (tracking the movement of money into and out of mutual funds), Dalbar’s and Morningstar’s data clearly show that the vast majority of people buy investments when prices are high, and they sell when prices are low.
For example, consider the returns of a fund that (according to Morningstar) averaged 15% per year for the ten years ending December 31, 2006. Morningstar says the average investor of that fund earned only 2.6% per year. In another fund that posted an 8% annual return, investors earned only 0.6%. A third, which posted a 7% average return, has an average investor return of –15%.
There’s such a large discrepancy between investment returns and investor returns because investors tend to buy funds only after they’ve risen in value. Funds attract media attention only after they do well, and fund companies place ads in magazines and newspapers only after the funds produce a great record they can tout. Investors agree that the results are terrific, and they assume that a fund that made lots of money in the past will continue to do well; so they buy. When those profits fail to materialize, they sell. Then they scratch their heads and ask, “How come I’m not making money with my investments?”
The solution: Buy and hold for years and years.