4 Ways to Improve Your Fund Returns

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Recent research from Morningstar shows that investors have earned about 7.7% per year on the average dollar they've invested in funds during the past decade compared with reported returns of 9.4% per year. Here to talk about how investors can close the gap in their returns is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy. Thanks for being here today.

Amy Arnott: Hi. Nice to see you again.

Dziubinski: Amy, this return gap that we've seen through this study is due in part to poorly timed fund purchases where maybe an investor is buying a fund after it's risen significantly or maybe sold too soon when it was been down in the dumps for a while. Tell us in real dollar terms what this type of return gap can do to a portfolio?

Arnott: If you take an investor who's maybe 50 years old and starting out with a portfolio of $100,000 and trying to save $10,000 every year for retirement, over the 15-year period, if that investor was able to earn the full total return, she would end up with about $1.6 million if she earned the average total return that we found in the study. But if there were some poorly timed purchases and sales and she ended up earning the lower investor return number, she would end up with only $1.3 million after 15 years. So, obviously, that difference is pretty significant at the end of that period, and if she's planning to retire at age 65, that's going to impact how much she can withdraw to cover annual spending needs during retirement.

Dziubinski: Exactly. So, based on these investor behaviors and this gap that we've seen, you've isolated a few strategies that investors should really pay attention to if they want to try to close this gap in returns. Your first suggestion is to hold a small number of widely diversified funds. Let's unpack that a little bit.

Arnott: Sure. So, these are things like a diversified U.S. stock fund, like a large-blend fund or a broadly diversified bond fund like an intermediate-term core bond fund, or maybe an asset-allocation fund that has a prebuilt diversification mix between stocks and bonds. And what we've found is that investor returns in those types of funds tend to be much better.

Dziubinski: In a similar vein, you suggest that investors perhaps avoid some very narrowly focused funds or sector funds because those type of funds, kind of, bring out the worst of our behaviors, right, as investors?

Arnott: Exactly. And we actually found some of the worst results in sector funds where we saw almost a 4-percentage-point gap between reported total returns and the returns that investors actually earned, as well as alternative funds where we also saw a really significant gap. So, I think the takeaway point is that those funds, even though they might look good on paper, they're very difficult to use effectively in a portfolio.

Dziubinski: Now, you also suggest that investors think about automating some routine tasks such as setting their asset-allocation targets or rebalancing. So, why does that automation, what does that do? Why is that so important?

Arnott: Well, if you're someone who follows the markets or even just following the daily newspaper, you're going to see economic news changing all the time. There might be headlines about inflation going up or going down. So, there can always be a temptation to try to shift your portfolio to position it well for whatever is going on in the market. But the problem is it's extremely difficult to do that well even for professional investors. So, really, the best approach is to come up with an asset allocation that makes sense for your own situation, your age, your time horizon, your risk tolerance, and stick with it and not try to shift your portfolio around because if you are trying to make shorter-term shifts, chances are that's going to hurt your results.

Dziubinski: And you also say a strategy to be thinking about is dollar-cost averaging can really help here. Now, we hear how making a lump-sum investment because the market tends to go up over time is a better strategy than dollar-cost averaging. You actually think dollar-cost averaging can help here.

Arnott: Exactly. So, if you have a lump sum to invest, you're typically going to get better results just because the market does tend to go up more often than not. But in terms of enforcing discipline and being able to live with your results, we actually found that dollar-cost averaging can be a significant help. We did see that dollar-cost averaging would have improved results in six out of the seven category groups that we looked at compared with investors' actual returns.

Dziubinski: It appears that all of these four strategies that you've outlined here all do have a common theme, right?

Arnott: Right. So, it basically comes down to just keeping it simple. And investing can be complicated, but it doesn't have to be. And really, if you simplify your portfolio, put things on autopilot, try to reduce the number of decisions that you need to make, chances are you're going to end up with better results.

Dziubinski: Well, it sounds like good advice, Amy. Thank you for your time today.

Arnott: Sure.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.