“Surprise! The returns reported by mutual funds are not actually earned by mutual fund investors.” This is how John Bogle, founder of Vanguard Mutual Funds begins the chapter titled The Grand Illusion in his 2007 book, The Little Book of Common Sense Investing. The “grand illusion” Mr. Bogle is referring to is the fact that mutual fund investors consistently fail to earn the returns of the financial markets. According to Bogle, during the 25-year period from 1980 to 2005, the return on the stock market (as measured by the Standard & Poor’s 500 index) averaged 12.5% per year, yet the average fund investor earned a mere 7.3%, or less than 60% of what the average fund returned.
Although recent studies employing more sophisticated methodologies have arrived at less startling results, their conclusions still present a grim assessment of the average investor’s track record. An example is the best way to demonstrate the implications of poor investor performance in stark dollars and cents terms. A difference of just 3% (7% vs. 4%) in annual returns on a $100,000 portfolio invested over a 30-year period results in dramatically different ending wealth balances. The 7% return would have generated $761,000 at the end of the 30-year period as compared to just $324,000 for the 3% return. This hypothetical investor who assumed 100% of the risk would have forfeited almost 60% of the return that he could have otherwise earned.
What’s the reason for such a stunning performance gap? Although some of the lag can be attributed to the high fees that investors pay to own most mutual funds, the main cause is the investors’ own behavior, specifically counterproductive market timing and fund selection. Stated simply, investors chase performance, pouring money into those asset classes (e.g. stocks, bonds, etc.) and mutual funds that have recently experienced the biggest gains, only to lose conviction and sell after experiencing an inevitable and painful decline.
Buying high and selling low is obviously a flawed investment strategy. Yet many investors fail to practice what common sense dictates and make this mistake repeatedly, causing permanent damage to their portfolios. At some level, this disconnect between rational thinking and emotional behavior is understandable because investment decisions are different from other types of decisions we make in life. With non-investment decisions, past experience is often a reasonable predictor of future performance. With investing, however, often the opposite is true. Not only is past performance an unreliable predicator of the future, but also recent past performance is in fact often a contrary indicator of what is to come. In other words, the types of investments that have recently declined in value the most may prove to be the better performing investments in the future. Unfortunately, this contrarian approach is easy to understand intellectually but emotionally difficult to implement. This is especially true during times of financial crisis when otherwise rational people are overcome with the fear that the future will bring even more bad news.
As powerful as emotions are and as difficult as they may be to overcome, successful investors understand they must do so. It begins with a realistic understanding of how the financial markets work. Sudden surges and frightening drops in the market are to be expected. The successful investor will avoid making impulsive decisions and instead, employ a long-term investment plan rather than succumb to the emotions of greed when the markets surge and panic when they plummet. It is clear that investors consistently fail to earn the returns that they should. It is time to change that.