Traditionally, when you look at the historical return of mutual funds, you are getting what is called a time-weighted return. For example, the 5-year return is what you would have gotten if you bought the fund five years ago and held it continuously until today, all the while reinvesting dividends.
Last year, Morningstar rolled out what it terms the Morningstar Investor Return, otherwise known as a dollar-weighted return. This measures the returns that investors actually achieved in that fund, based on dollar inflows and outflows. It’s actually pretty interesting: If investors as a whole timed their purchases correctly and bought more shares when the fund was low, then their returns would actually be higher than the time-weighted returns. If, instead, investors waited until the fund performed well before buying in, and then sold their shares when the price was lagging, then their dollar-weighted returns would be lower than the time-weighted return. Guess which one happens almost all the time?
To find these numbers, go to Morningstar and type in any symbol in the quote box. Let’s take my very first mutual fund purchase, Janus Mercury (now Janus Research), symbol JAMRX. Then click on Total Returns, and then finally on the Investor Returns tab on the top. You should find this:
Yikes. If you take the 10-year historical return, which includes both the big Tech bubble and crash, instead of the happy 10% annual return number most people see, the average investor actually lost 2% annually during this period. They tried to time it, and lost tons of money in the process. (I was one of them.)
Now, don’t think this performance chasing doesn’t apply to index funds. It does. Check out the Investor Returns for the classic Vanguard S&P 500 Index Fund, VFINX:
Not quite as bad, but the average owner still lagged the fund’s performance by over 1% a year. What do we learn from seeing these Investor Returns?
Making a decision on which mutual fund to buy based on past performance is simply not a good idea. What happens when the performance starts to lag? Since you’re making decisions based on past performance, then you’re probably going to find another fund that’s been doing well recently, and then jump on that ship instead. It’s just a never-ending cycle of losing money.
This is why when I am looking at mutual funds to purchase, I completely ignore recent performance. I couldn’t tell you the recent returns of any of my fund holdings. The things I do look at are – the asset class and what index it follows, the expense ratio, and the tax efficiency. Maybe the fund minimums too, but that’s it.
(I also ignore the Morningstar Star rating system as I think it’s pretty useless as well, but that’s another post.)
2. Volatility matters. Buy-and-hold works… if you hold! You keep hearing that people shouldn’t own too much in stocks if they can’t tolerate the risk. You can see why by viewing the Investor Returns on the more volatile funds. They stink! According to this CBS MarketWatch article, the funds with the greatest relative volatilities had dollar weighted returns of just 62% of time-weighted returns.
When people see ups and downs on the Great Stock Market Ride, as a whole they are horrible at timing when to get on and when to get off. When (not if, when!) the market crashes again, people who aren’t prepared will panic and get off the ride. But when will they get back on? The result is lost money.
Here, the lesson is that even if you do plan on sticking with index funds, you must remind yourself during the rough patches that staying the course will be most profitable in the end.