Market Timing Is Hard: Actual Investor Returns Lag Fund Returns

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When you look up the historical performance of mutual funds, you are typically 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, with no additional purchases or withdrawals.

But real life is different. People add money in, people take money out. Morningstar calculates an additional metric called Investor Return [pdf], also known as a dollar-weighted return. This measures the returns that investors actually achieved in that fund, based on dollar inflows and outflows. This means that 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/or sold their shares only after the price was temporarily lagging, then their dollar-weighted returns would be lower than the time-weighted return.

Russell Kinnell of Morningstar has a revealing article and chart comparing the performance of the average fund with the average investor, broken down by category like US stocks or municipal bonds. This higher-level view is useful because it takes out any noise you might get from just looking at a specific mutual fund. Did the average investor’s market timing efforts pay off? Here are the results, broken down into the past 3, 5, and 10-year periods.

Source: Morningstar

We see that across almost every category and every timeframe, the investor return lags the fund return. That gap also tends to grow over time, with an average underperformance of nearly 1% a year over the last 10 years. That’s a lot of money. The S&P 500 is basically back to it’s all-time high back in 2007, even though it was a crazy roller coaster in between, and it seems most people didn’t time it correctly. It would be wise to remember this consistent underperformance this the next time you think about market timing, or buying something simply because it did well in the recent past.

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  1. The reality is that eventually everyone has to take their money out. Will the market be up or down at that moment? (or those moments?) No one can predict that, and it is entirely beyond the control of the individual. This is why Social Security was created, to spread the risk. This is why Social Security or something like it cannot be allowed to disappear and should in fact be strengthened.

  2. Good article, but there is a logical flaw. The market is a zero sum game (with the exception of commissions, spreads, etc). The market, by definition, gets the market return. If a group of investors, call them group “A”, persistently mistime the market and lose, this is only possible if another group of investors, call them group “B”, gain.

    The interesting question is who are these two groups of investors? Your article talks about group “A”. Who is the group “B”? Because they must exist.

  3. I’ve heard about this but to see these numbers is interesting. I wonder what a simulated dollar cost averaging approach would look like. For instance, few people actually buy and hold, an approach which should have allowed the investor to achieve the time weighted return.

    Most people save periodically, monthly or roughly every couple of weeks, as they get paid, and invest money into the market on that kind of regular schedule. That should result in a dollar weighted return above the time weighted return in this volatile but non-directional market (since 2007), because one would be acquiring more shares in the down market.

    Presumably your table above includes a sub-set of investors who are buying and holding, and another group that is doing DCA. If that’s the case, and that sub-set of Bogleheads is equaling the TW return and the sub-set of DCA investors is actually beating the fund over a given time period, the rest of the market timing investors are underperforming the fund by an even greater margin than this table would suggest.

  4. @Baughman – Well, these are open-ended mutual funds, so the group B could be anyone else in the market buying the underlying holdings, including institutional investors or hedge funds. The problem is, it’s possible they charge such high fees that the money may just go to the financial industry instead of the investors. If you beat the market by 1%, but charge 1% in fees, you’re still pretty much just matching the performance of a low-cost index fund.

  5. @Jonathan. Good response. If that is the case, then the findings are just re-documenting the well established fact that net returns = gross returns – fees. If the article is intending to convey a market timing element, I remain curious who is group “B”.

    But I think I agree with you. This isn’t a market timing issue at all. It’s just a re-hash of the law of net returns in the face of high fees.

  6. Well, not exactly. Somebody is “winning”. The mutual funds are open-ended, so if you buy more shares of the fund, then it goes out and buys more shares of whatever is inside (Apple, Intel, Home Depot, JNJ, whatever) on the open market. Same thing in reverse when it sells, it has to sell some stock on the open market.

    This means that on that open market, in a granular level, someone is gaining in comparison to the buy&holders, but it’s impossible to know who as it could be a billion different people in different ways as each single share could theoretically be bought by a different person.

    The fees argument is that even if there was “smart money” beating “dumb money”, much of that outperformance (esp if ~1%) may end up as fees paid to an intermediary and may not flow to any investor.

  7. One question-if the market is generally up in the time frame (as it is in these cases) wouldn’t you expect below market returns for each individual investor on average? That is, say I put in 10,000$ a year every year (saving for retirement), then each time I buy more stock, generally I pay a higher price than my initial investment, driving down my personal return over that length of time.
    Or to think about it another way-if the market could be bought for $15 trillion 10 years ago and now it costs $25 trillion (or whatever, I’m not going to look up the precise numbers) then the ‘the market’ as a whole is going to have better returns than every one of the 10 trillion dollars that got invested in the middle.
    Or am I missing something?

  8. StLhawk:

    Yes, you’d be paying a higher price each year when you invest, but you wouldn’t necessarily be getting a lower return on those dollars invested each year. For example, if the market went up 7% each and every year, then you’d get a 7% per year return on all dollars, regardless of when you invested them. The dollars invested earlier would compound into higher amounts but that is strictly a result of their being invested for a longer period of time, not a higher annual return.

    Now, since the market does not go up every year or have uniform returns each year, you can actually “average down” in a market that starts and finishes a period at the same level but goes up and down within that period if you dollar cost average. You will buy more shares at lower prices and fewer at higher prices. In a market that moves up over time but is volatile, which is to say spends time above and below that trend line, you will be better off with a dollar cost averaging approach then you would have been if the market just moved up the same % amount each year, assuming the same compound return.

  9. @StLhawk – As Andy pointed out, you have to think in terms of percentage returns that are annualized, not in absolute dollars.

  10. Diversification and holding for the long term is the only real analysis needed since it’s based solely in common sense. Timing the market is a pointless exercise and has been proven time and again to lead to lower average returns than buy and hold.

  11. It’s fallacy to say that there is always a winner and loser in the stock market, and concept of the market return really is not that meaningful other than as benchmark.

    1) The market price is merely the last trade. I could have brought 100 shares for $1, and the last trade is $2 for 1 share. On paper I’m up $100, and that would be considered the market return, but since I haven’t liquidated it means nothing.

    2) Stocks are not just bets, they are actually companies so it’s no zero sum. For example lets say I brought a successful company in it’s entirely for $1, and it makes $3 over the course of the year. If I were to then sell that company with it’s $3 in the bank for $2, I and then the buyer were to liquidate the company both I and buyer would be better off.

    However, I do want to add that it’s almost a given that the average investor over a short period of time well lose the market index. The “average” investor as rule is buying when it’s and selling when it’s low – that’s how the market moves up and then down….

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