Washington: Think you can guess the direction of the market? Surely, any fool could have foreseen the market's collapse after Lehman Brothers failed in September 2008. And by March 2009, stocks were so cheap that they had nowhere to go but up.
Market timing seems so easy in hindsight. What's more, plenty of professionals — including brokers, advisers and investment newsletters — stand ready to offer you guidance on when to trim your exposure to stock funds and when to boost it.
A groundbreaking study by Morningstar shows what a terrible price investors pay for market timing. During the past decade, the average investor's return trailed the average fund's return by 1.5 per cent. And it came during a decade when the major market indices suffered losses or produced paltry returns. The study also showed with which firms clients were most likely to lose money. More on that later.
Ironically, investors are good fund pickers, the study shows. On average, investors tend to shun high-priced funds and to invest in funds that, over time, beat their category averages. On average, about two-thirds of funds fail to even match their benchmark index. But Morningstar finds that investors, in aggregate, buy above-average funds.
Bad market timing, however, overwhelms skillful fund picking. During the decade that ended December 31, 2009, the average fund of all types — including stock funds and bond funds — returned an annualised 3.18 per cent. But the average investor dollar earned an annualised 1.68 per cent.
What are investor returns? They're what the average dollar invested in funds earns — as opposed to what the average fund returns. Suppose a fund that holds $10 million returns 20 per cent in its first year.
Attracted by those boffo results, assets swell suddenly to $100 million at the start of the second year, but the fund gains just 2 per cent in its second year. The fund is still up an annualised 10.6 per cent for the two-year period. But hapless investors, most of whom came late to the party, gained only an annualised 1.83 per cent.
To calculate the results, Morningstar studied monthly cash flows in and out of mutual funds. I've been fascinated by the subject of investor returns for years. Several other companies have made efforts to estimate investor returns, but I think Morningstar is the first to dig deeply enough into the data for me to trust the results.
Fund shares
Volatility is the investor's enemy. As you might expect, the more volatile the fund, the more investors are likely to badly time buys and sells of fund shares.
Take Janus Twenty, which boasts a terrific long-term record but comes with high volatility. Over the past 10 years through June 30, it has lost an annualised 2.9 per cent. The average investor dollar, however, has fallen much more: an annualised 6.9 per cent.
Investors in high-voltage funds — such as technology and natural-resources sector funds and China funds — did even worse.
By contrast, lower-risk Vanguard Wellington, a balanced fund that holds about two-thirds of assets in stocks and one-third in bonds, returned an annualised 5.9 per cent over the past decade. Wellington investors have enjoyed an annualised 5.5 per cent return, losing just four-tenths of a percentage point annualised to poor timing.
On average, investors in balanced funds beat the return of the average fund over the past 10 years. Investors in both US-stock and municipal-bond funds, meanwhile, trailed average fund returns by an annualised 1.37 per cent and 1.61 per cent, respectively.
Hiring a pro didn't appear to help. Morningstar analysed investor returns of institutional funds and funds sold with sales charges, both of which are typically purchased with the "help" of advisers. Measured against no-load funds, which individual investors usually buy on their own, these funds produced roughly the same poor results.
"In aggregate, they're all losing money to poor timing," writes Morningstar analyst Karen Dolan.
Investor psychologists wouldn't quibble with the results, but they would put a different spin on the cause. They would say that investors aren't consciously trying to time the markets but that they rush into rising funds based on greed and sell dropping funds based on fear. So they buy high and sell low.
Choice
Morningstar's data allow us for the first time to determine which fund firms made money for their investors and which lost money. You can't blame the firms entirely, of course, because investors choose when to time buys and sells.
The take-away from Morningstar's study is as important as it is unsurprising. Choose your allocation to stock funds and bond funds based on your personal circumstances and tolerance for risk — not on what your gut or some guru tells you the market will do next. Stick to that allocation until your situation changes.
In choosing funds, don't look just at past total returns. Consider a fund's standard deviation, a measure of its volatility. The three-year, monthly standard deviation of Standard & Poor's 500-stock index is currently about 21. You can find a fund's standard deviation at http://Morningstar.com. The average fund has a volatility ranking between 5 and 6.
Use those numbers as your benchmark. Favour funds with lower standard deviations. Think long and hard before buying any fund with a higher standard deviation. If you do, remember that its returns are likely to bounce around a lot, so make sure you have the temerity to hang on during the inevitable awful times
