As the market rally persists, many investors will no doubt be kicking themselves and wishing that they had bought in earlier. Some will convince themselves that they better get on board or risk missing out on this bull market. There are many good reasons to invest money, but choosing to get in because of the potential gains that you could have made is not one of them. In the same way that people capitulate and sell out near market bottoms, there is also a big behavioral driver that seems to make people capitulate and join the herd towards the end of big bull markets. I am not saying that we are poised for decline (I am not a good market timer), but simply noting that buy or sell decisions made on the basis of what you wished you had done last month or last year is often truly dangerous.
Through the end of April of 2013, we no longer hear about the ‘lost decade’ because the trailing ten-year annualized return for the S&P500 is almost 8%. Not bad. The ‘market’ has delivered a substantial return, albeit with some big bumps. But how have investors actually fared over recent years? A great way to get a sense of how investors time their purchases and sales is to look at Morningstar’s investor return data. These return numbers are the asset weighted returns for mutual funds. If investor returns are notably less than a fund’s returns, this means that investors added or removed money to the fund at the wrong times. Most often, this occurs for one of two reasons. One way that investors tend to lag fund returns is by jumping into or out of the market at the wrong times, with subsequent returns that are worse than simply buying and holding an index fund. The second common driver of under-performance is that investors tend to ‘discover’ a new manager after a period of out-performance, and add money to his or her funds. There is often surprisingly little persistence in the ability of a manager to out-perform, so investors flow into funds after great performance and just in time for worse performance. For this reason, the actual investor returns may be poor even though fund returns are high.
Let’s start our exploration of investor decisions with Vanguard’s S&P500 index fund (VFINX).
According to Morningstar, investors in VFINX have under-performed the fund by 1.11% per year over the fifteen year period, out-performed the fund by 0.37% per year over the ten year period, and under-performed the fund by 3.34% per year over the most recent five year period. How could investors have performed so poorly even as the market has recovered in recent years? The data suggest that investors must have pulled money out during the decline, missed a substantial part of the early recovery, and then put money back in. The evidence that money has flowed back in is that the three year period shows a more modest (but still substantial) 2.07% per year of under-performance. This is an example of the first effect in action: bad timing.
Now let’s look at the problem of investors putting their money with a manager after he has gotten a lot of media attention for a string of past high returns. Consider the Fairholme Fund (FAIRX). The fund’s manager has received plenty of media coverage, including being named Morningstar’s fund manager of the year for 2009. FAIRX has an admirable ten-year track record, with annualized returns of 11.37% per year.
The data on investor returns shows, however, that investors in Fairholme fund have achieved a paltry 3.77% per year over this ten-year period. This enormous disparity between the fund returns and investor returns is the hallmark of a fund that achieves high returns early on, attracts lots of new investors, and then performs far worse than it did in its early years. Perhaps most intriguing here is that this under-performance is not just due to Fairholme’s early years. Even over the most recent three years, investors in this fund have averaged -1.54% per year while the fund has returned an average of 3.37% per year. This level of under-performance is stunning, not least because an S&P500 index fund (VFINX) has returned an average of 12.64% per year over the same period.
The long-term cost of investors’ bad timing choices is nothing short of catastrophic in terms of long-term wealth accumulation and retirement planning. Average investors are jumping in and out of the market and specific funds based on emotion, reactions to the media, or other factors and are severely reducing the returns that simple index funds, purchased with a consistent investment discipline, have provided.
In summary, the lessons are straightforward. Putting money into stocks because they have performed well in recent years (or taking money out after a big decline) is truly like shutting the barn door after the horse is gone. Investors need to look at risky assets on their own merits and decide whether the expected returns justify the potential for loss. Giving money to a manager after he or she has generated substantial returns is trickier. It is natural to want to see evidence that a manager can build an out-performing portfolio. The question is whether anyone has the ability to determine whether out-performance will continue. In most cases, the track record of investor returns suggest that we might just as well bet on horse races as try to predict which managers will out-perform in the future. The losses that investors have, on average, sustained by chasing performance in the market or with active managers can be so large as to make investing remarkably unprofitable.
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