The Investment Scientist

How investors lost money: evidence from mutual fund flows

Posted on: July 30, 2009

Like to hurt yourself?

Investors don’t need outside help to hurt themselves. I’ve been writing about how ignoring conflict of interest, hidden fees, and not taking the necessary time to do due diligence costs investors a great deal of money. Today, I’m going to show you another way they self-inflict pain, and what to do about it.

Let’s imagine you’re in your car. Your vehicle is traveling at 60 mph. How can you, as passenger, only be going 30 mph? You can’t. It’s an impossibility. Nevertheless, it happens in the financial world all the time.

The shocking truth

Morningstar did a study comparing mutual fund returns (the vehicle), and mutual fund investor returns (you). What they found was shocking! In all 14 mutual fund categories, investor returns lagged behind fund returns. (See table below.) Take emerging market funds for example, this category returned an average of 15.6% over the last 5 years. Investors in these funds earned an average return of only 3.8%. That’s a whopping 11.8% lag. How so?

Fund Category Fund Return Investor Return Investor Lag
Large-Cap Blend -1.4% -5.7% -4.3%
Large-Cap Growth -1.7% -7.7% -6.0%
Large-Cap Value -1.8% -2.2% -0.4%
Mid-Cap Blend 0.4% -3.0% -3.4%
Small-Cap Blend -0.5% -6.9% -6.4%
Europe/Pacific 3.1% 0.5% -2.6%
Emerging Markets 15.6% 3.8% -11.8%
Financials -10.5% -28.6% -17.9%
Health Care -1.3% -3.1% -1.8%
Communications 1.9% -3.7% -5.7%
Energy 8.6% 4.0% -4.6%
REITs -2.5% -11.8% -9.3%
Technology -2.6% -8.3% -5.7%
Utilities 5.5% 2.1% -3.4%
Total and Simple Averages 1.0% -3.5% -4.5%

Source: Morningstar

Investors are horrible market timers

The chart below, from Fidelity Investments, shows how stock fund inflows peaked just before the market tanked, and outflows were strongest just before the market rallied.
[turn on image display to see mutual fund flow chart]

Why do we have this herd mentality? The answer: millions of years of evolution. We’re hardwired to seek safety in the crowd. If the crowd runs in one direction, our instinct tells us to follow. Warren Buffet can resist the herd instinct, but he is an exception. Let’s accept this: most of us ain’t Warren Buffet.

Mutual fund companies encourage herd movements

Mutual funds spend big money to advertise their top performing funds. Investors are taught to rotate into hot sectors (funds) at the expense of those that haven’t done well. That’s sell-low-buy-high, not a recipe for long-term investment success.

How to counter our financially destructive instinct?

Tune out the noise: Recognize financial news and advertisements for they are – noise. Don’t let the it cause you to act on your worst instinct. Just tune these distractions out.

Have a plan and stick to it: Suppose your plan calls for 60% stocks, 40% bonds and the stock market just tanked. Now your allocation is at 50/50. If you stick to your plan, you would move 10% from bonds to stocks. This is a sell-high-buy-low strategy, and a recipe for long-term investment success.

If you can’t do the above, an advisor acting in fiduciary capacity can help you. After all, two heads are better than one.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

5 Responses to "How investors lost money: evidence from mutual fund flows"

[…] cause you to take counterproductive actions. The proof of that comes from studies showing that the returns earned by investors are well below the returns of the very funds in which they invest — a result caused by reacting to information that is nothing more than […]

[…] from 0.9 to 2.2 percentage points, depending on fund volatility. (It can be much higher — over 10 percentage points — for other types of […]

[…] investors’ tendency to hurt themselves knows no national border. The Chinese hurt themselves like their U.S. counterparts, by trying to […]

Investors respond to fear and greed, instead of following a carefully analyzed strategy that includes a defensive and offensive component. Buying and holding has neither of those.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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