Here’s what goes through the minds of most investors when they read about the stellar returns advertised by mutual funds: “I owned that fund, and I didn’t get anywhere near those returns.”
One article estimated investors end up with less than 20 percent of the annual returns of the mutual funds they once held.
After inflation and taxes, many investors are in the red.
This is not an isolated problem. It’s true for many major mutual funds. For example, the difference between the returns of the Fidelity Aggressive Growth Fund and the returns realized by shareholders for the period from January 1, 1998, to December 31, 2001, was an astounding 26.9 percent. You can find a chart with the largest gaps among the largest funds here.
Over longer periods, the same results were found. For the twenty-year period from 1990 to 2009, the returns of the average stock fund investor were only 3.17 percent. The S&P 500 Index returned 8.21 percent.
The reason isn’t hard to understand. Most investors are advised by brokers. Brokers typically encourage them to chase returns by investing in “hot” funds with stellar recent performance records. The funds get a massive influx of cash and are unable to repeat their prior performance.
How can you avoid this investor trap? It’s stunningly easy.
First, stop dealing with a broker or any adviser who tells you he or she can “beat the markets.” This includes virtually all brokers.
Second, do not invest in any actively managed stock or bond fund. By “actively managed,” I mean any fund where the fund manager attempts to beat the performance of a given benchmark.
Third, don’t try to pick one sector of the market that will outperform any other sector. Instead, invest in a globally diversified portfolio of low-cost stock and bond index funds in an asset allocation (division of your portfolio between stocks and bonds) suitable for you.
In essence, you are fundamentally changing the way you invest. Instead of engaging in discredited and unreliable practices like market timing and fund manager picking, you are capturing the market returns of the world’s economies.
This simple strategy will get you almost—but not completely—to your goal of capturing 100 percent of the returns of the funds in which you invest. Investors in index funds typically capture between 75 and 88 percent of the returns of the fund, which is not bad. They fail to capture the balance because they don’t have the discipline to stay invested during the tough times.
A purely passive investment adviser can bridge the gap. These advisers (full disclosure: I am a passive investment adviser) focus on educating investors to stay the course in volatile markets, which changes investor behavior and increases returns. There is ample data demonstrating that passive advisers who educate their clients in this manner (and advise them to rebalance their portfolios) achieve returns for their clients that exceed the advertised returns of the funds in which they’ve invested. The rebalancing requires their clients to purchase funds that are going down and to sell funds that are going up, which accounts for this impressive result.
If you have the discipline to do this yourself, you may not need an adviser. Otherwise, consider hiring one, but be sure to limit your search to someone who focuses on your asset allocation and recommends investing only in a globally diversified portfolio of low-cost index funds, exchange traded funds, or passively managed funds.
Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read and The Smartest 401(k) Book You’ll Ever Read. His latest book is The Smartest Retirement Book You’ll Ever Read.