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August 4, 2013

How investors beat themselves

“Surprise! The returns reported by mutual funds aren’t 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 percent per year, yet the average fund investor earned a mere 7.3 percent, or less than 60 percent 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 percent (7 percent vs. 4 percent) in annual returns on a $100,000 portfolio invested over a 30-year period results in dramatically different ending wealth balances.

The 7 percent return would have generated $761,000 at the end of the 30-year period, compared to just $324,000 for the 3 percent return. This hypothetical investor who assumed 100 percent of the risk would have forfeited almost 60 percent 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.

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