Where Did The Average Investor's Money Go?

One of my investing heroes is John Bogle, known as the father of index funds. He's an eloquent thinker and writer, one who takes on the establishment by making important points. He's also a fine speaker. I recently read a speech he gave in 2003, titled "How the Mutual Fund Scandals Will Serve Fund Owners."

Among other things, Bogle offered some statistics that made me stop slouching in my chair. Get a load of this:

From 1984 to 2002, the S&P 500 (which reflects most of the U.S. stock market) averaged an annual return of 12.2%. Mutual funds, meanwhile, averaged a 9.3% return. And individual mutual fund investors like you and me? Well, on average, we averaged ... 2.6%.

You read that right. Not only did funds, in general, underperform, but individuals underperformed the funds. And by quite a bit, too. This perplexed me, because the market average is so much higher, and so many individual stocks sport higher averages, too. For example:

Data: Morningstar.com. *Through July 31, 2008.

Why funds falter
It's probably not a surprise to you that most funds underperformed. We at The Motley Fool have been crowing about this for more than a decade, urging investors to consider index funds, which let you at least meet the market's return.

But why do funds underperform? Well, there are several explanations:

• Fees. Bogle pointed to these as a main culprit. Managed stock funds often sport expense ratios (which are annual fees) well above 1%, and on top of that there are often other fees, such as sales loads. If the funds otherwise would have met the market average, once you remove the fees, they'll be underperforming.
• A short-term focus among fund managers can also be blamed. Many managers feel pressured to deliver strong results each quarter. That's just not reasonable, as both good stocks and the overall market will rise and fall from time to time. Trying to guess the timing will lead to many suboptimal decisions.
• Another reason to frown at many funds is frequent trading. That can lead to greater tax hits (from short-term gains, versus long-term ones) and commission costs.

How individuals err
So we've explained away the fund performance. But how could the average fund investor end up with such lousy returns, when they're investing in funds with higher averages? The answer to this: our brains.

We investors, whether we're in stocks or funds, tend to make all kinds of irrational decisions, engaging in insane investing and buying and selling stocks for the wrong reasons. Many great thinkers have commented on these human misjudgments. Some blunders we commit include:

• We don't follow Warren Buffett's advice, to be fearful when others are greedy and greedy when others are fearful. Instead, we tend to sell when the going gets tough (i.e., when stocks are down, and therefore on sale) and to buy when the market is booming (i.e., possibly near a high point, from which it will retreat).
• We are impulsive. We may, for example, jump into a stock or a mutual fund just because it has done very well in the past -- even just in the past year. Well, that doesn't mean it will do so well again. Lots of funds have one anomalous, amazing year -- and that can be enough to attract excited and naive investors. Heck, I was among them myself long ago.
• Think about how the market achieves its long-term average return: by sitting there, with all its holdings in place, for a long time. It's when we jump in and out of stocks, trying to time the market, that we end up missing some important boats. The folks at SEI Investments reviewed all the bear markets since World War II awhile ago and found that stocks rose an average of 32.5% in the 12 months following the bottom. Yet if you missed the bottom by just a week, that return fell to 24.3%. Waiting three months after the market turned cut your gain to less than 15%. See how timing can hurt?

What to do
So what should you do? Well, when you invest in mutual funds, be sure to look for ones with great long-term records and managers you trust. Don't just look at lists of the past year's best performers. Consider also funds with low turnover.

If you'd like some pointers to some great funds, I invite you to sign up for a free trial of our Motley Fool Champion Funds newsletter, where I've found a bunch of winners myself. Its picks are beating the market by about 18 percentage points.