This Trap Will Doom You to Terrible Returns

Anytime the market moves up or down in dramatic fashion, investors start questioning whether a long-term investment strategy really makes any sense. After all, if you could grab all the upside without suffering through the big drops, then you'd end up with incredible returns.

In reality, though, most investors fall short of earning the returns they would get if they simply bought shares of an investment and held it. A recent Morningstar study cited in the New York Times is just the latest to confirm that whether you're looking at stocks, hedge funds, or mutual funds, most people simply aren't any good at timing the market.

A closer look at fund timing
Along with more typical data on mutual funds, Morningstar also offers an extremely interesting set of statistics. For each fund, Morningstar calculates what it calls investor returns, which simply measures how well the typical investor fared after considering cash inflows and outflows from all other investors.

How it works is pretty simple. If a fund experiences big inflows only after it posts strong returns -- a fairly typical situation, given the way that many investors chase after performance -- then its investor returns will be lower than the standard return figures, which assumes that shareholders are using a simple buy-and-hold approach throughout. Conversely, if investors put money into the fund before it posts robust returns, then the investor return will outperform the standard numbers.

Taking a closer look at a few representative funds reveals an interesting trend:

Fund

Fund Type

10-Year Annual
Total Return

10-Year Annual
Investor Return

Growth Fund of America (AGTHX)

Domestic Stock

3.3%

2.0%

Fidelity Contrafund (FCNTX)

Domestic Stock

3.0%

2.2%

Vanguard Emerging Markets Stock Index (VEIEX)

Emerging Markets Stock

10.6%

7.7%

American Century Target Maturity 2025 (ACTVX)

Zero Coupon Bond

8.1%

2.2%

Third Avenue Real Estate Value (TAREX)

REITs/Real Estate

9.4%

5.2%

Source: Morningstar. Returns as of July 31.

It's apparent that it doesn't matter which type of mutual fund you look at; bad timing decisions plague investors in nearly every fund. I had to search for a long time before I found a fund where the investor return beat out the buy-and-hold return. Based on that, I suspect they're few and far between.

Buying high, selling low
Even more disturbing are some of the short-term figures on investor return. For Vanguard's emerging-markets fund, the difference in one-year returns comes to over 11 percentage points, suggesting that many investors chased the strong performance of stocks like America Movil (NYSE: AMX  ) , Petroleo Brasileiro (NYSE: PBR  ) , and Infosys (Nasdaq: INFY  ) until the bottom fell out, and then bailed before their recent rebound.

You'll see the same phenomenon in real estate funds. The Third Avenue fund's differential is a less extreme 5.8 percentage points -- but it still suggests the same investor behavior in response to the similar down-then-up stock charts of real-estate companies like The St. Joe Company (NYSE: JOE  ) , Vornado Realty Trust (NYSE: VNO  ) , and Brookfield Asset Management (NYSE: BAM  ) .

How to beat the timing phenomenon
In order to get your returns up to what they should be, it's not enough simply to buy and hold stocks or funds. You also have to pay attention to when you buy certain types of funds. Even if you're not consciously chasing performance, you're still more likely to hear about a certain type of fund when it's doing well.

One trick is to stay contrarian and look for out-of-favor investments. Stocks like Las Vegas Sands (NYSE: LVS  ) that many people left for dead earlier this year have bounced back sharply in recent months, even if the casino industry isn't completely out of the woods yet. Similarly, looking at funds that no one's talking about -- say, perhaps, utility sector funds -- might lead to better opportunities than just jumping on more popular investments after they've already gotten bid up.

As tempting as market timing is, it's unlikely that you'll succeed at it. You're better off with a simple long-term investing strategy that rides out the ups and downs and earns you reasonable returns over time.

Are you still searching for the perfect investment? We've found one that could give you exactly what you want. Take a look here and see for yourself if it's the right one for you.

Get out of the market-timing trap with help from our Motley Fool Champion Funds newsletter service. Each month, you'll get fund recommendations, analysis, and much more. Click here to get a full-access 30-day trial absolutely free.

Fool contributor Dan Caplinger does his best not to buy the hottest new thing, hard as it is. He doesn't owns shares of the companies mentioned in this article. Fidelity Contrafund and Third Avenue Real Estate Value are Motley Fool Champion Funds recommendations. Petroleo Brasileiro is an Income Investor selection . America Movil and Brookfield Asset Management are Motley Fool Global Gains picks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy always has perfect timing.


Read/Post Comments (1) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 12, 2009, at 3:17 PM, spokanimal wrote:

    Re: Las Vegas Sands...

    The best turn-around candidates are most under-valued BEFORE the industry is "completely out of the woods".

    True contrarians prognosticate, they don't react.

    Spok

Add your comment.

DocumentId: 962733, ~/Articles/ArticleHandler.aspx, 7/24/2014 1:42:05 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement