The gap between fund returns and investor returns

We advocate that investors choose a diversified portfolio of stocks and bonds, with the percentage in each depending, to a large degree, on their overall risk tolerance (the higher the risk tolerance, the higher the allocation to stocks). When the markets move and the actual weights deviate from the target weights, investors should then periodically rebalance by trimming those asset classes which have done best and buying those assets classes which have not done as well. This simple rebalancing technique removes much of the emotion from investing.

Emotions can have a negative impact on investment returns. Many investors respond to short-term market moves by buying assets after they have gone up and selling assets after they have declined in price. This is just the opposite of what we do when rebalancing our client accounts.

Russel Kinnel at Morningstar wrote an interesting article on this topic (“Mind the Gap 2011,” 4/18/11). He compares a mutual fund’s total returns with the fund’s investor returns, which take investor cash flows into account. If investors pour money into a fund after the fund has gone up, and sell after the fund has gone down in price, the investor returns will be less than the total returns of the fund.

Kinnel writes “In 2010, the average domestic fund earned a return of 18.7% compared with 16.7% for the average fund investor, making for a gap of 200 basis points. For the trailing three years, that gap was 128 basis points. For the past five years, it was 98 basis points, and for the past 10, it was 47 basis points.”

This shows the average domestic stock fund investor consistently demonstrates a poor sense of market timing.

Sticking with a long-term investment plan and not letting fear or greed unduly influence your portfolio decisions can increase your portfolio returns over time.