How to Make the Most From Your Funds

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Mutual funds have opened the door to investing for millions of people. Yet even though many mutual funds have posted attractive returns over the long run, their shareholders often don't reap all of the benefits of their success. Failing to make the most of the mutual funds you own can cost you a huge amount of money.

One of the big mistakes people make with mutual funds is chasing performance. By buying top-performing funds after they've already posted huge gains, investors hope that like a big roller at the craps table, the hot hands that produced those high returns will stay on their hot streaks. In the end, though, their impatience often causes them to miss out on big parts of the long-term returns they could earn.

What you're doing wrong
Mutual fund researcher Morningstar took a look last year at the reality of how fund investors invest compared to the funds' reported returns. Specifically, the researcher examined when investors bought and sold shares of the funds they owned and adjusted its fund return data to account for the actual amount shareholders had invested in the fund. Doing that produced a more realistic assessment of how the typical fund shareholder did, as it gave more credit to returns when many investors actually had money in the fund.

Morningstar found that in nearly every category, fund shareholders did markedly worse than the overall results of the fund would suggest. During the so-called "lost decade" from 2000 to 2009, the typical U.S. stock fund had an average annualized return of around 1.6%. But the corresponding investor return was just 0.2%. In other words, as meager as total returns have been in recent years, investors have left just about all of their return on the table because of their mistakes.

Running away from performance
Of course, over the past two years, confidence in the stock market has risen dramatically, thanks to the rebound from 2009's lows. Interestingly, though, investor return numbers suggest that after having seen a decent recovery in their portfolios, investors are getting out while the getting's good.

For instance, look at the Vanguard 500 Index Fund (VFINX), the original S&P 500 index tracking fund. During 2008 and 2009, its investor returns closely tracked the overall performance of the market. But in 2010, investor returns started falling off, and over the past 12 months, the difference has widened to more than four percentage points. That may stem from the weak performance of tech megacaps Microsoft (Nasdaq: MSFT  ) and Cisco (Nasdaq: CSCO  ) , both of which have struggled from hiccups in their long records of growth. In contrast, small-cap indexes have outperformed the S&P 500, even reaching new all-time highs at the same time that the large-caps languish well below their 2007 record levels.

Fund investors do tend to be a fickle bunch. After a decade of outperformance at Bruce Berkowitz's Fairholme Fund, the fund has performed abysmally so far in 2011. Berkowitz's biggest bet, AIG (NYSE: AIG  ) , has seen its share price cut in half after strong performance in 2010, and retailer Sears Holdings (Nasdaq: SHLD  ) continues to defy the manager's hopes of a turnaround.

In response, the fund is facing shareholder redemptions. As one Fairholme analyst recently commented, with nearly a quarter of its assets in cash, Fairholme is well-positioned to handle redemption requests without having to liquidate stock holdings at low prices.

Yet investor reaction to Fairholme's performance makes little sense from a longer-term perspective. Berkowitz has made no secret of his belief that financials would outperform the market going forward. Fund investors have known that big banks Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Goldman Sachs (NYSE: GS  ) play important roles in Berkowitz's investing thesis and had ample opportunity to get out when those stocks were doing well. To leave only now that those returns have evaporated shows just how backward-looking many fund investors are -- and explains why if Fairholme returns to its former glory, many former shareholders will miss the boat.

Stay the course
It's hard to fight through periods of losses. But as Morningstar's research shows, investors too often fall prey to getting out of mutual funds after the worst of losses are over, only later jumping back in and in the process missing out on a good portion of their long-term returns. Unless you fundamentally disagree with a top fund's new direction, then sticking with it makes the most sense -- and if you do think a fund has lost its way, don't wait for losses to come before you make a switch.

Many mutual fund investors have made the switch to exchange-traded funds. Find out about three promising ETFs in the Motley Fool's special report on ETFs -- it's free.

Fool contributor Dan Caplinger always tries to squeeze the last drop of return from his investments. He owns shares of Fairholme and Vanguard 500 Index Fund. The Motley Fool owns shares of Microsoft and Bank of America, has created a bull call spread position on Cisco Systems, and has shorted Bank of America. Motley Fool newsletter services have recommended buying shares of Microsoft and Cisco Systems and creating a diagonal call position in Microsoft. 

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy helps you make the most of what we know.

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