Morningstar Minute: Maximizing investors' fund returns

Investors tend to buy high and sell low, and that's a costly problem.

Christopher Davis 30 May, 2017 | 11:00PM

 

 

Christopher Davis: Investors are often their own worst enemy. They tend choose investments that already have done well and sell too quickly when they struggle. Put another way, investors buy high and sell low. As a result, they often don't fare as well as their investments.

Bad timing is a costly problem. Over the past decade, the typical diversified equity fund investor lagged the typical diversified fund by 1.4 percentage points per year. To put that in perspective, the difference between what the fund earned and what the investor received equates to nearly $20,000 in lost gains on a $100,000 investment over the decade.

Morningstar measures investor performance by calculating money-weighted returns, which we call Investor Returns. Investor returns adjust returns to reflect flows in and out of the fund. It's not a perfect measure, but it gives a good idea of how well investors performed. Investor returns fall short of total returns across virtually every market we've studied.

How can you avoid this outcome? I have a few ideas.

For one, if the cause of poor investor returns is unproductive activity, sometimes the best solution for investors will be to do nothing at all. This isn't always possible or desirable. Inaction isn't a good reason to not follow your financial plan. But if your behaviour is driven by market ups and downs, you probably won't make a good decision.

Second, the antidote to emotion-driven decision-making is discipline. One great enforcer of discipline is dollar-cost averaging. That's what you're doing if you sock away a percentage of your paycheque every month. The benefit is that you limit the risk of bad timing from your process. This is great for investor returns: In Australia, the whole country dollar-cost averages as part of its government-mandated retirement savings system. The average Australian retirement fund investor beat the average retirement fund by a wide margin over the past decade.

Last, think carefully before investing in a fund with high volatility. Investors historically have used these funds badly. They buy when they're hot and sell when they're not. This is what leads to bad investor returns.

Successful investors aren't necessarily smarter than anyone else, they're just more disciplined and keep their emotions in check. Selecting good investments is only part of the battle. Using them well matters too.

For Morningstar, I'm Christopher Davis.

About Author

Christopher Davis

Christopher Davis  Christopher Davis is Director of Manager Research at Morningstar Canada.