Tuesday, August 12, 2008

Mutual Fund Returns Versus Individual Investor Returns

While listening to the podcast over at SoundInvesting.com, I was referred to an article by famed investment columnist Jason Zweig. In this article he spoke about the difference between what the mutual funds present as their investment returns in market materials and what individual investors actually made. To get to the point, here is the crux of the argument: The returns earned by mutual fund investors is much lower than that of the posted total returns.

Before I begin, I want to ensure you that this is not yet another bash the mutual fund post. I have enough of those over at The Dividend Guy. To prove this, have a look at this image from one of Zweig's articles that talks about this difference in market returns versus individual investor returns. The difference is stunning!

With respect to mutual funds, the difference in individual investor returns is also much different than the returns touted as total returns.

Stunningly, while the average fund generated a 5.7% annualized total return over the four years, the average fund investor earned just 1%. In every category except two (equity income and utilities), investors earned less than their funds did.

The main question from this research is why is there such a huge discrepancy between what mutual funds earn and what their investors actually achieve while invested in those funds. In my mind, the answer is very simple.

It has everything to do with individual investor behaviour and trying to chase those hot mutual funds. You know how it works - you go over to Monrningstar or MSN Money and do some extensive searches for mutual funds that have been kicking butt over the past 3, 5, or even 10 years. You arrive at a list of the best performing stocks and you invest in them, thinking that your returns are now going to match the returns of that fund. Guess what - on average your returns differ from those total returns posted by the fund by about 4.7%. Over a number of years that can translate into differences of thousands of dollars.

As investors, we need to change our behaviour and stop chasing the hottest mutual funds or the hottest dividend stocks. We also need to ensure that we do not get suckered into a fools game of trying to match those marketed returns of the mutual funds. We will not match those returns, no matter how hard you try or how lucky you get.

My suggestion is to avoid mutual funds altogether. The fees charged by these funds make it even harder (impossible) for you to earn the same posted returns they advertise. Instead, focus on building a core portfolio of internationally diversified index funds and if you want add some dividend growth companies, but only if you have the time and inclination to track those stocks. And most importantly do not get discouraged if your returns don't match the returns of what seems like everyone else's portfolio. Over the long term your returns will begin to match that of the market. The key is consistency and a long term focus.

This article was written by The Dividend Guy. You may email questions or comments to me at info@thedividendguyblog.com.


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