The ideal situation for most fund investors is a nice steady upward climb. This way, just about any point that you buy in is a good one and you get positive reinforcement, which will encourage you to invest more.
Unfortunately, the aughts didn't give you that. For the broad market indexes, there were four years of double-digit losses and four years of double-digit gains with two years of single-digit gains sprinkled in. Those severe reversals are tough on fund investors who tend to read a lot into recent performance. The past two years were particularly challenging. The bear market of 2008 led to mass redemptions of equity funds just as those equity funds were primed for their best year of the decade. Ouch.
We now have data on Morningstar Investor Returns for the full decade so that we can see just how investors did and learn some lessons that will help you make more out of your investments.
How Do We Calculate Morningstar Investor Returns?
Investor returns tell you how the average investor in a fund fared. We take monthly cash inflows and outflows and then calculate the returns earned on those flows. As with an internal rate of return calculation, investor return is the constant monthly rate of return that makes the beginning assets equal to the ending assets with all monthly cash flows accounted for. The gap between investor returns and total returns shows you how well investors timed their purchases and sales. (For all the details on the calculation, you can check out the two-page fact sheet here or the 10-page methodology document here.)
Mind That Gap
To see how the average investor did overall, we calculated asset-weighted investor returns and then compared them with the category averages. A couple of years ago, doing this revealed that the average investor often did better than the average fund because, while their timing was off, they often picked bigger lower-cost funds. However, the whipsaw of the past two years has meant that, in most categories and in the aggregate, investors have done worse than the average fund.
You can see the summary data in the table below. For the whole shmear, with data on all the individual categories, see this PDF.
Investor Returns in the AughtsCategoryAst-Wgt 3yr Investor ReturnAverage 3yr Total ReturnAst-Wgt 5yr Investor ReturnAverage 5yr Total ReturnAst-Wgt 10yr Investor ReturnAverage 10yr Total ReturnU.S. Equity Funds-5.18-4.960.640.910.221.59Intl Equity Funds-5.17-4.553.275.232.643.15Balanced-2.15-1.721.572.223.362.74Alternative2.36-1.685.483.038.078.55Taxable Bond3.8126.96.36.1994.005.33Municipal1.012.501.453.022.964.57All Funds-2.71-2.141.662.381.683.18Data through 12/31/2009
The grand total for the average investor in all funds in the aughts was a 1.68% annualized return, compared with 3.18% for the average fund. The biggest gaps between investor returns and total returns were in municipal-bond funds, which returned 4.57% annualized. Investors only earned a 2.96% return. While the muni world's problems in 2008 got less attention than the stock meltdown, it was enough to lead some investors to redeem, only to see muni funds snap back in 2009.
In U.S. equities, the average investor earned a scant 0.22% annualized, compared with 1.59% for the average fund. As I noted above, two bear markets and two snap-back rallies made for a really challenging time for many fund investors.
Interestingly, balanced fund investors did manage to beat the averages. They earned a 3.36% annualized return, compared with 2.74% for the average fund. A mix of bonds and stocks leads to moderate results, and more investors stick with these funds through the down periods. In theory, it shouldn't matter if you hold a stock fund and a bond fund separately or get the same exposure through an allocation fund, but in practice it seems that boring balanced funds don't push fear or greed buttons that throw people off. As Jack Bogle says, emotion is the enemy of the investor.
Looking at individual categories, there were some interesting cases of investors beating category averages. In the five foreign style categories (foreign large-growth, etc.) investors beat the averages in some cases by a wide margin. It may be because big funds such as American Funds EuroPacific (AEPGX) and Vanguard Total International Stock Index (VGTSX) have much lower fees than the average fund in these rather pricey categories and produced strong performance. It could also be that foreign funds' superior returns prior to 2008 led investors to keep the faith through the bear market.
Not everything was peachy overseas. The average global real estate fund returned an annualized 10.74%, but the average investor gained about 0.65%.
How to Be on the Right Side of the Gap
While some investors tend to make mistakes by reading too much into recent performance and letting fear and greed prod them into making a bad situation worse, there's no reason you have to do the same. Here are a few suggestions for improving your portfolio performance.
� Go back over your past statements and look at how funds did after you sold them. If you tended to sell at the wrong time, try to steer clear of higher-risk funds that led you to make those decisions. You can do this by reviewing all of the fund's calendar-year returns as well as its Morningstar Risk rating. Maybe instead of a hot regional fund, for example, you should buy a balanced fund for your next investment.
� Write down your planned holding period for each fund and the goal you are trying to reach. Another reason that people panic amid sell-offs is that they have a mismatch of investments with their goals. If you need the money in three years, don't put it in a stock fund. However, if you need it in 20 years, don't abandon your plan because you lost money in year two.
� Evaluate a fund's performance over a manager's entire tenure rather than reading too much into a single year's returns. Short-term returns are very noisy--it's only the long term that lets you evaluate a manager's skill.
� Consider valuations of your fund's holdings. Because rallies and sell-offs are often overdone, fund portfolios tend to be real bargains after a long sell-off and rather unattractive investments after a long rally. This is how fund managers think. They're looking through the windshield rather than the rearview.
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Russel Kinnel does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.