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The big mistake mutual-fund investors make

Reprinted courtesy of MarketWatch.com.

To read the original article click here

You have probably heard about what’s known as the DALBAR effect. It’s the fact that, as a group, mutual-fund investors underperform the funds in which they invest.

Quick background: The reason for this effect, amply documented over nearly a quarter-century by a Boston research firm, is investors’ behavior.

In short, mutual fund shareholders tend to buy and sell based on their emotional reactions to bull markets and bear markets, real or expected. Their timing is usually wrong, and in the end they would have done better by buying and holding.

 (For a more detailed look at this effect, check out this article.)

OK, here’s the bad news: If you’re average, chances are you will underperform the funds that you own.

But here’s the good news: I’ve discovered a group of investors who are apparently doing just the opposite: They are outperforming the funds they own.

To understand how that’s possible, you’ll need to bear with me as I walk through some steps. For your patience, you will be rewarded at the end with my suggestion for how you too may be able to perform what seems to be a minor financial miracle.

I first discovered this anomaly while I was comparing target-date retirement funds offered by Fidelity and Vanguard.

What I found is more than just coincidence: It appears in the latest 10-year performance results in four pairs of retirement funds — those with target dates of 2020, 2030, 2040 and 2050.

Let’s take the Vanguard and Fidelity 2020 funds as examples. The numbers are clear on two points.

  • The Vanguard fund has higher returns.
  • While investors in the Fidelity fund (consistent with the DALBAR effect noted above), achieved lower returns than those of the fund itself, investors in Vanguard’s 2020 fund achieved higher results than the fund.

Here are the numbers:

For the 10 years ended March 31, 2017, the Fidelity 2020 Freedom FundFFFDX, -0.06%  compounded at 4.47%, while investor returns (provided by Morningstar Inc.) were only 3.13%. The Vanguard Target Retirement 2020 FundVTWNX, -0.14%   compounded at 5.23%, and investor returns were 6.53%.

How is it possible to have such a large additional return?

The Vanguard fund return is based on the assumption of a lump-sum initial investment made at the end of March 2007 with no further additions or withdrawals other than reinvestment of dividends.

The investor return tracks the dollars that investors as a group actually invested, and when they invested them. (I’ll come back to that point in a moment.)

Here are the comparable results for three other pairs of target-date funds.

2030: Fidelity FFFEX, -0.18%   grew at 4.66%; investor returns were only 3.53%. Vanguard VTHRX, -0.20%   grew at 5.31%; investor returns were 7.58%.

2040: Fidelity FFFFX, -0.21%  grew at 4.78%; investor returns were only 4.17%. Vanguard VFORX, -0.22%   grew at 5.69%; investor returns were 8.49%.

2050: Fidelity FFFHX, -0.18%   grew at 4.61%; investor returns were 6.92%. (No, that’s not a typo; stay tuned.) Vanguard VFIFX, -0.22%   grew at 5.71%; investor returns were 8.70%.

In every case, the Vanguard funds achieved higher performance. That’s not hard to explain: Fidelity’s funds charge higher expenses, hold more cash, use active management and have much higher turnover.

But those things don’t explain how investors in five of these eight funds did the seemingly impossible: outperformed the funds in which they invested.

I think the answer is to be found in investor behavior.

Target-date fund shareholders are typically setting money aside methodically for their eventual retirement through regular withdrawals from their paychecks.

Read: Have value funds become too valuable?

You probably know the name for this practice: dollar-cost averaging (DCA), investing the same amount every month or every pay period.

DCA lets investors take advantage of the rise and fall of stock prices by automatically buying more shares when prices are low and fewer shares when prices are high. The result: The average price paid per share is lower than the average of all the prices at which those shares were bought.

I think this explains the higher investor returns in five of these eight funds.

Two questions remain:

  • Why did Vanguard investors outperform while those in three of the four Fidelity funds lagged?
  • Why did investors in Fidelity’s 2050 fund do better than investors in the other three Fidelity funds under study?

Though I can’t back up my answers with numbers, I’ll take a stab at answering these questions. Both answers, I believe, come down once again to investors’ collective behavior.

To answer the first question, I think Vanguard simply attracts a different sort of investor than Fidelity.

  • Vanguard marketing emphasizes the firm’s low costs, its index funds, the higher quality of its stocks and bonds and its buy-and-hold culture. Vanguard urges investors to accept the returns of the market.
  • Fidelity’s marketing focuses on active managers who pick stocks, backed up by impressive stock analysts. Fidelity urges investors to seek higher performance.

OK, but so why did investors in Fidelity’s 2050 fund outperform the fund itself, while those in the 2020, 2030 and 2040 funds underperformed?

Here I have to speculate. I’m guessing that investors with an eye on a 2050-ish retirement are younger and often have less money with which they want to try to beat the odds.

Read: Some harsh truths about saving and investing

For this reason, I suspect that such investors are less likely to try to second-guess the market’s ups and downs and more likely to simply trust their funds.

I promised a suggestion for how you might be able to outperform a fund you’re invested in.

My best suggestion is to use dollar-cost averaging. This will keep your average cost-per-share down. And it will keep you investing regularly. Both are extremely good habits.

However, at the risk of throwing cold water on a good idea, I have to point out that DCA makes a positive difference only over extended periods, and only during periods when the market ends up higher than it started. (The reason for this is simple: Even if you buy at below-average prices, if your investment loses money over the long run, it loses money. Sorry about that.)

Read: 10 ways to retire early — it’s not easy, but it’s doable

The latest 10-year period (like most 10-year periods) was a positive one for stock investors. The most recent eight years were especially strong, with the S&P 500 index SPX, -0.30%  appreciating by more than 300% (including reinvestment of dividends).

Although things won’t always be that good, the market historically goes up about two-thirds of the time and down only one-third.

So if you take a long-term perspective, keep your expectations realistic and adopt excellent investing habits, I think there’s a good chance you, like many of Vanguard’s target-date investors, will be able to do the seemingly impossible.

Check out my latest podcast, “How financial ‘fake news’ can ruin your financial future.”